Growth Investing: A Strategy Focused on Companies With Growth Potential

Investors employ many different strategies when it comes to constructing their portfolios and choosing what to invest in.

One popular approach is called growth investing.

Growth investing focuses on companies that the investor feels are poised for growth.

Instead of looking for large, established businesses, growth investors often focus on smaller businesses with the potential to expand.

This strategy offers the possibility of significant gains if the investor can choose the right stocks to buy.

However, choosing the wrong companies could lead to low growth or even losses from the investor’s portfolio.

Common Indicators for Growth Investing

With any strategy that revolves around investing in individual companies, investors have to do a lot of research.

Before you buy shares in any business, you want to make sure that you understand the company, including:

• how it operates
• how it’s performed in the past
• its risks
• opportunities going forward

With so many companies in the world, it’s impossible to do your due diligence on every single one of them.

To help narrow down their options, many investors use a few indicators to screen for companies that may have the potential to grow.

Historical earnings

Growth investing revolves around finding businesses with the potential to expand in the future.

One of the most commonly used indicators when searching for growth companies is their historical earnings.

• Are the company’s earnings increasing from year to year?
• Is the growth fast or slow?
• Is the growth consistent or does it fluctuate?

Growth investors often look for companies that have shown consistent earnings growth over the past few years.

Typically, investors will screen stocks for a certain level of growth, such as an average earnings increase of 5% per year.

Projected earnings

No one can predict the future, but that doesn’t stop companies and analysts from doing their best to estimate and project a company’s future earnings.

Growth investors want to see revenue growth, so they’ll often look for businesses that expect to increase their earnings going forward and that have communicated that to their investors.

Projecting increasing earnings is a sign of confidence as undershooting an announced projection can hurt a company’s share price.

Profit margins

A company's profit margin is the percentage of the money it makes from sales that it doesn’t spend on generating those sales.

The higher a company’s profit margins, the more money it retains to spend on other things, like investing in the business’s growth.

Growth investors often look for strong profit margins because they indicate an efficient company that is using its resources well and that can generate additional capital to reinvest in expansion. 

Additionally, businesses with higher profit margins will see better earnings growth from increasing sales. Those with low-profit margins won’t get the same benefit from boosting sales numbers.

Return on equity

Return on equity (ROE) measures a company’s profit compared to the shareholder’s equity (how much shareholders invested in the business).

Growth investors look for stable or increasing return on equity because it shows effective management that succeeds at producing profits from the money invested in the company.

Common Counterindicators

When researching a company to see if it’s a strong potential investment, investors need to look for negatives as well as positives.

These are some popular measures that investors use as a negative indicator, predicting poor performance in the future.

High debt/liabilities

If a company has high levels of debt or other liabilities, it can be a bad sign for the business’s future.

While debt can be a useful tool for helping a business expand, high levels of debt are generally a bad thing.

Even if a company is profitable in the immediate future, its debt will eventually come due, forcing the business to spend money on debt payments instead of continued expansion.

Decreasing sales, revenue, or profits

Growth investing is all about buying shares in companies poised to grow.

If a business is seeing decreases in sales, revenues, or profits instead of increases, that’s an obviously negative sign for growth investors.

Recent change in management

A company’s management can have a big impact on the business’s success.

Strong management can help a business operate efficiently and expand. Poor management can lead a company to squander its resources and opportunities for growth.

If a company changes its management team, it can be a sign of internal trouble and a desire to have an outsider fix the situation.

New managers can succeed and help companies grow, but a recent change in management may give growth investors pause if they’re considering buying shares.

A history of frequent management changes is also a negative sign that could indicate a company that is trying to find the formula for success rather than one that knows how to succeed and grow.

Growth Investing Options

There are many ways to execute a growth investing strategy, each with pros and cons.

Individual stocks

One common strategy for growth investing is to buy shares in individual companies.

Buying stock can be exciting because you’re putting your money where your mouth is based on how you expect the company to perform in the future. If you’re right and the company continues to grow, you can be rewarded with significant gains.

Because you’ve invested directly in the stock, instead of a mutual fund or ETF that holds many different shares, those gains won’t be diluted by losses or lesser gains from other stocks held by the fund.

However, buying individual stocks comes with risk.

The reality is: 

If you choose the wrong company, you’ll likely lose money. That’s why it’s important to build a diversified portfolio.

Even if you choose one bad investment, good performances from the other stocks in your portfolio can make up for the losses.

An important thing to keep in mind when investing in individual stocks is that some brokerages charge commissions or other fees for each transaction. This can add additional costs when you’re building your portfolio.

Growth mutual funds

Mutual funds make it easy to build a diversified portfolio while only buying shares in one fund.

There are thousands of mutual funds out there and each follows its own investing strategy.

Many funds use a growth investing strategy and focus on buying shares in companies poised to expand. You can research different growth mutual funds and choose one to invest in.

This will let you invest in many growth stocks at once, even if you don’t have enough money to buy shares in dozens or hundreds of different companies.

One of the drawbacks of mutual funds is that there’s a cost to investing in them.

Funds charge a fee, called an expense ratio. The fee is quoted as a percent of the amount you invest that you pay each year.

For example, if you invest $10,000 in a mutual fund with a 1% expense ratio, you’ll pay $100 in fees each year to own the fund.

Even small fees can have a significant impact on your returns over time, so you want to find a fund that charges low fees.

Growth ETFs

Exchange-traded funds (ETFs) are very similar to mutual funds.

They let investors buy shares in a single fund that owns shares in many different companies. They also charge a fee to investors who own them.

The primary difference is:

ETFs are traded on the market while mutual fund transactions only occur at the end of each trading day.

This makes ETFs more suitable for investors who want to actively trade their shares.

Mutual funds also tend to have minimum investment requirements. Investing in ETFs can let investors avoid those requirements.

The downside:

Most brokerages only let investors buy whole shares, so if an ETF is worth $50, you can only invest in $50 increments. With a mutual fund, investors can add to their investment in whatever increments they desire.

When to Sell

When to sell an investment is a difficult decision and there is no single correct answer.

No matter when you sell shares in a company, those shares could go on to gain or lose value.

When growth investing, investors commonly track popular indicators for stocks in their portfolio.

For example, an investor may track their holdings’ earnings growth or debt. If these indicators start to show that a company is losing its status as a growth stock, it could be time to sell.

Capital Gains Taxes

When you sell an investment for a profit, you incur capital gains taxes.

The taxes you have to pay will vary with how long you’ve held the investment.

Short-term

Short-term capital gains taxes are charged against any profits on investments held for one year or less.

Short-term capital gains are taxed just like your ordinary income.

That means that you’ll pay higher taxes if you have a higher income.

Long-term

Long-term capital gains taxes are charged on profits from investments owned for longer than a year.

These rates are lower than the short-term capital gains rate, so it can sometimes be worth holding an investment for slightly more time to take advantage of the lower tax rate.

Before You Dabble in Growth Investing

Before you start investing, there are a few things you should prioritize.

Be prepared for financial emergencies

Remember that everyone should have an emergency fund. Having some cash on hand can help you avoid the need to take on expensive debt if your car breaks down or you have a medical emergency.

Common advice is to keep between 3 and 6 months’ worth of expenses in your emergency fund as it should be enough to weather even a period of job loss.

Take advantage of retirement accounts

You should also take advantage of tax-advantaged space, such as your 401(k) or IRA.

Saving in these accounts reduces the taxes that you have to pay which can save you a lot of money in the long run.

Once you have your financial house in order, you can think about implementing a growth investing strategy in your taxable brokerage account.

Remember:

All investing is subject to risk, so only invest money that you can afford to lose and take steps to reduce your risk, such as by building a diversified portfolio.

You'll need a brokerage account

To invest, you’ll need to open a brokerage account. There are many companies that offer brokerage accounts, but not all of them are made equal.

Look for a brokerage with low or no account maintenance fees and no trade commissions.

If you want to invest some of your money in mutual funds or ETFs remember that many brokerage companies offer their own funds and offer perks for investing in those funds.

You might want to choose a brokerage based on your desire to invest in its mutual funds.