Growth Investing: How to find growth stocks to invest in

How to find growth stocks

When it comes to investing, there are various schools of thought and different investing strategies that investors can use to make money in the stock market. One extremely popular strategy is Growth Investing: How to find growth stocks to invest in.

This strategy involves buying shares of companies whose businesses are expected to increase their revenue (or profits) at a faster-than-average rate. Good mature companies typically grow their revenue and profits by single-digit CONSISTENTLY year-in-year-out.

Growth companies, however, are expected to grow these financial metrics at a much faster rate, typically in the double-digit arena. The best growth companies that can grow these key financial metrics for an extended period f time tend to be rewarded with a higher share price, enabling early investors to profit from their massive share price appreciation.

Investors in growth companies are typically not interested in the payment of dividends. Most growth stocks do not yield a dividend. Instead, as previously highlighted, capital appreciation takes center-stage.

Do note, however, that high rewards tend to portend high risk. There is no free lunch in this world. Therefore, it is important to know the basics of what growth investing entails, how to find the right kind of growth stocks in their early stage that is poised to take off, and lastly its associated risks.

In this article, I will be touching on these few key areas of growth investing:

1. What is growth investing and what are growth stocks?
2. How to find growth stocks to invest in
   • Mass-consumer products
   • Benefiting from macro-trends
   • Growth stocks that interest investing legends
   • Using stock-screening tools
   • Key financial metrics to look out for
3. Risks of investing in growth stocks

Without further ado, let’s get started on this topic of growth investing.  

What exactly is Growth Investing?

Value vs. Growth: Which is superior?

I have previously written about value investing in this article: Value Investing in Singapore where I compared the historical performance (last decade) of value stocks vs. growth stocks vs. broader index.

Value Investing is the “art” of finding stocks that are undervalued or trading below their so-called “intrinsic value”. This is a term made famous by legendary investor Warren Buffett. Warren Buffett loves to find value companies trading substantially below their intrinsic value, ie: there is a “margin-of-safety” or MOS buying into these companies.

The problem is that the art of calculating a company’s intrinsic value is often fraught with uncertainties and is a subjective manner (for example: what discount rate to use, what terminal growth rate to use etc). Any small variations in these “inputs” can result in a drastically different intrinsic value calculation. Heard of the phrase “Garbage in, garbage out”?

Calculating the intrinsic value of a company is often more of an art than science and that process is prone to errors and uncertainties, hence the “MOS” component.

If the intrinsic value calculation is “wrong”, there is still a MOS or buffer, so to speak.

Value investors who do not wish to calculate a company’s intrinsic value can use the “short-cut” method which is to use certain traditional financial metrics to gauge if a company exhibits “value” characteristics.

These financial metrics are typically your Price to earnings ratio (PER), Price to book ratio (PBR), debt to equity ratio, etc.

Buying companies that show lower-than-average PER/PBR ratios vs. industry peers or the companies’ historical trading multiple bands can be considered a form of value investing.

In this article, I talked about using 6 screening criteria to identify value stocks in Singapore using the Uncle Stock Fundamental Stock Screener, some of the stocks identified such as iFast has since shown huge price appreciation from the point of writing.

Growth investing on the other hand is not about finding companies that are undervalued or trading below their intrinsic value. In the first place, it might be difficult to accrue an “intrinsic value” to these stocks because many of them are not generating earnings (or not much) in the first place.

Instead, growth investing is all about identifying stocks that are exhibiting “above-average” growth and are primed to grow their businesses strongly over the foreseeable future. These stocks are often “bleeding” or loss-making at present as management focus on “heavy-spending” to increase their market outreach.

Hence these stocks tend to look “expensive” using traditional financial metrics such as PER or PBR. If they are profit-making, they tend to be trading at PER multiples easily more than 30x, a multiple that is commonly seen in growth stocks vs. value stocks where PER multiples tend to be less than 15x (also depend on the industry which they are in).

A growth stock is thus a company that is expected to increase its profit or revenue at a much faster rate than the average business in its industry or the market in general. They appeal to many investors because, in the current era of “easy” money, Wall Street has placed a “premium” for companies exhibiting higher-than-average growth vs. safe but boring companies with low or no-growth.

With that said, where should one look for growth stocks?

How to find growth stocks to invest in

Mass-consumer products 

Many of the biggest growth stocks out there are also mass-consumer related stocks that most will be familiar with. Stocks like Amazon.com, Netflix, etc all started as small players in their respective markets but slowly convinced mass consumers to purchase from them or subscribe to their services. That helped drive huge revenue and profit growth over the years, turning these growth stocks into multi-bagger winners.

So how can one identify the next Amazon or Netflix which are still in their infancy stages? One method is to look at the products and services that you are currently using regularly. Ask yourself: Are there any products or services that you are using frequently? Which are the companies behind these products and services?

A quick internet search can help you find the companies that are behind the products or services that you have grown to love. If they are publicly traded companies and still in the early stages of the growth cycles, then you may have stumbled upon a potential winner.

For example, shoe retailer Crocs is now viewed as a cool and fashion trendy item to own, especially after its recent partnership with Justin Bieber which saw all its limited-edition shoe being sold off in a matter of hours.

How about Pinterest, the visual discovery engine for finding ideas like recipes, home and style inspiration, and more. An increasing number of users are engaging with this social search platform to find inspiring ideas.

I am not implying that these companies are going to be the next Amazon or Netflix, but they might be interesting mass consumers’ growth stock ideas for further investigation.

Benefiting from macro trends

The best growth stocks tend to benefit from a massive change that happens in society. Companies that can capitalize on a trend that takes years to play out can often see their revenue and profits grow for years on end and generate strong returns for their happy shareholders.

So, what are some interesting macro trends to look out for?

I have written about several interesting investment trends for 2020 in this article: 6 Top Investment Trends (2020). I also talked about 8 technology trends that might benefit from COVID in this article.

Just to highlight a number of them here in this article:

Digitalization of payment:

The market assumes that COVID-19 related adoption of contactless/digital payments is a near term benefit for payment providers, offsetting some of the consumers’ spending headwinds. However, contactless and digitalization of payments is part of a multi-year secular growth driver in payments, with COVID-19 as just the latest accelerator.

While these companies are no longer “small” some of my favorite plays in this category can still be multi-baggers over the next 5 years, stock such as Square, Paypal, and Adyen. This is in addition to your typical beneficiaries of this digital payment trend, stocks such as MasterCard and Visa.

Ad spending shifting from offline to online:

As confinement measures were introduced around the world, out-of-home and cinema advertising shrank almost instantly; print advertising also fell.

Meanwhile, in-home media usage went up. TV viewership has climbed, but digital consumption has increased even more: the use of social platforms and streaming services has risen almost everywhere; gaming has also grown dramatically.

Advertisers have adapted by following consumers, which means prioritizing digital advertising. The online environment is favorable for “direct response” campaigns – those encouraging quick purchases by consumers – an attractive proposition for brands spending cautiously and looking to drive sales.

That’s why more advertisers are spending their ad dollars on online channels so they can still keep in touch with their consumers. This spending shift is creating a huge opportunity for companies that excel at reaching consumers online.

Some of my favorite “small” companies in the segment include stocks like Hubspot, Roku, and Magnite.

Jump starting health-tech

Investors probably do not fully appreciate the impact COVID-19 will have on accelerating big tech’s entrance into healthcare. There has been a significant shift in consumer preferences towards digital health solutions which is likely here to stay.

Digital health is the provision of healthcare through the use of technology so that it can supply cutting-edge services to improve health outcomes such as

Remote medical consultations via video conferencing (Teledoc)

Electronic health records (Veeva)

Patient monitoring systems and wearable device integrations that can monitor a patient’s vital signs such as heart rate and blood pressure (Fitbit, Garmin)

Use of mobile technologies such as smartphones for healthcare delivery (Apple’s health-kit)

Fitbit makes for an interesting growth stock, with the company barely affected by COVID-19. However, do note that the competition might be rather intense in its core business of selling smartwatches or wearable devices, an area in which the 1000-pound gorilla, Apple, shares a slice of the market pie.

These are just a few of the macro shifts that are taking place in our society today. The next time you notice one happening, do a little research to see if any companies will benefit from the trend.

Following growth investing Gurus

Wall Street fund managers usually have huge research budgets at their disposal to find great businesses. It can be an eye-opening experience to pick through their recent buys and sells to see that stocks they like.

There are several growth fund managers that I like to follow and they are a wonderful source of stock ideas. Here are a few of my favorite growth investors.

Pat Dorsey

Dorsey is the Founder of the Chicago-based Dorsey Asset Management and is a former director of Equity Research at Morningstar. He is also the author of the highly acclaimed books The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth.

He believes investors should target 10 to 15 moated businesses that can compound at high rates over time and make a long-term investment in them to create major wealth.

Some of his current growth stock holdings are Smartsheet, Upwork, Paypal, Roku, Avalara, and Alteryx.

Catherine Wood

Catherine Wood is the CEO and CIO of ARK Investment Management LLC, the company behind the popular ARK-family of ETFs which has done extremely well in recent years.

She believes that ARK can identify large-scale investment opportunities in the public markets resulting from technology innovations centered around DNA sequencing, robotics, AI, energy storage, and blockchain technology.

Some of their key growth stock holdings in their super popular ARK innovation ETF are Tesla, Invitae, Square, Crispr Therapeutics, and Roku.

Stephen Mandel

Billionaire hedge fund manager Stephen Mandel founded Lone Pine Capital 23 years ago and boasts one of the best long-term track records in the industry. The all-star manager made nearly $1bn last year, one of the top earners among the world’s biggest hedge fund managers.

In the latest filing, his fund purchased growth stocks such as DataDog, Zoom, and Booking Holdings, although his largest addition in the quarter was to PayPal Holdings and Facebook. His largest holding is in Shopify.

There are also a plethora of websites out there that make it easy to track and rank what notable growth investors are doing, including Dataroma, TipRanks, and Guru Focus. Growth investors can visit any of these sites and quickly learn what many big-time money managers have been buying and selling in recent months to come up with stock ideas of their own. 

Stock screening tools to identify growth stocks

Besides tracking investing gurus known for their growth stock picks, I do my screening of stocks which I use to find growth “gems”. There are several stock screeners out there for investors to choose from, however, my personal favorite FREE screening website to use is FinViz. This website has data on more than 7,000 companies and investors can input different parameters to help them find stocks that fit their criteria.

Another useful screener which I believe ranks among the very best is this website called Stock Rover. However, it is not free but the basic plan, which comes in at just US$7.99/month allows one to screen for more than 8,500 US stocks, etc with lots of customizable views and metrics.

The above-highlighted screeners are predominantly centered on fundamental criteria. For those who wish to use a technical platform to find growth stocks that are trending or having strong momentum, I personally use the Traders GPS platform which is a proprietary platform that is developed by Collin Seow. Collin runs the Systematic Trading Course that was recently voted the Best Investment Course to take in Singapore by Seedly, with close to 1,000 reviews written (4.9 stars out of 5.0), almost 3x that of the next best course.

Once I have identified a growth stock that meets my fundamental criteria, I will head over to the Traders GPS platform to better time an entry. For example, the platform identified ZM as a strong trending stock in play back in late August with an entry price of around US$280/share.

That stock is now a double-bagger over the short course of 2 months.

Another growth stock which the platform has recently identified is Datadog, a stock which growth investment guru Stephen Mandel also owns.

For those who are interested in finding out more about The Systematic Trader course, you can join in their SMT Masterclass live webclass (attend online) workshop where Collin will demonstrate to you first hand how his system works and how easy it is for you to “Follow the System” (FTS) to find good trending stock candidates to buy into before they start running higher. 

Key Financial Metrics for growth stocks

Here are a few metrics that I regularly use to screen the market for growth stocks:

Market Cap:  I look for companies that have at least US$500m in market cap. This is considered very small in the context of US stocks but it ensures that I exclude penny counters while yet at the same time take into consideration small-cap stocks that have multi-bagger potential.

Sales growth: A key metric when evaluating growth stocks is how fast are these companies growing their sales. While they might not yet be profitable on the bottom line, they are at least growing their top-line by a high double-digit rate every year.

Gross margins: I will like my growth stocks to be one that generates a high level of gross margin. This demonstrates a certain level of pricing power. I have previously written about SaaS companies that have high gross margins. These are companies I like which have both a recurring revenue business model which is also of a high margin nature.

Improving margins profile:  While growth stocks might be loss-making due to the need to re-invest profits and resources into human resources and R&D etc to gain an edge over their peers, ie gain market share, these stocks must exhibit a certain level of operational leverage where at least their gross profit margins are growing alongside rapid sales growth.

Balance Sheet: While debt isn’t always a bad thing, I don’t like to invest in companies that carry huge amounts of debt on their balance sheet. That’s why I like to use the debt-to-equity ratio to eliminate highly indebted companies from my search. This ratio compares the amount of total debt that a company has to its shareholder equity, which can be thought of as the net worth of the business. A good rule of thumb is to set the debt-to-equity ratio below 30%.

With these parameters in mind, let’s run a stock screen using the following criteria:

1. Based in the US
2. Market Cap over US$500m
3. Sales growth of at least 20% on average over the past 5 years
4. Debt to equity ratio below 0.30
5. Gross margin (now) > Gross margin (1-year ago)

There are a total of 37 stocks which meet these criteria based on Stock Rover screener and below, I identify 5 counters which are below US$20bn in market cap and make for interesting candidates to further investigate:

While there is no bullet-proof formula for creating the best list of growth stocks, using screening tools like Finviz and Stock Rover can be a great way to identify potential winners in their early stages.

Take for example the company LHC Group, which is not likely a company which most is familiar with but its share price has grown by 380% over the past 5 years vs the S&P500 return of 90%.

LHC Group Inc provides post-acute health care services to patients through its home nursing agencies, community-based services agencies, hospice agencies, and long-term acute care hospitals.

The company’s home health service locations offer a wide range of services, including skilled nursing, medically-oriented social services, and physical, occupational, and speech therapy.

Its hospices provide end-of-life care to patients with terminal illnesses through interdisciplinary teams of physicians, nurses, home health aides, counselors, and volunteers. Its other service segments are Home and community based, Facility-based, Hospice, and Healthcare Innovations.

Risks of Investing in growth stocks

Growth Investing is seen as riskier for two main reasons. First, it involves paying “more” for a company in relative terms and so there is a greater potential for substantial price declines. Second, because so much of a growth stock’s value is predicated on future gains, even a small change in investors’ perception of that potential could have a large impact on the share price.

Take for example the stock Fastly. It is a fast-growing counter that is still loss-making. The counter was trading at a hefty sales multiple of 30+x price to sales (not price to earnings) before a disappointing earnings guidance by management, one which reduces forward quarterly revenue guidance by just $4m ultimately shaved c.$3-4bn off its market cap over the last couple of trading sessions.  

That volatility is why, while it generally makes sense to have a minimum five-year timeline when investing in the stock market, growth-focused investors benefit from an even longer horizon.

Growth investors have to be willing to take on risk, but the rewards can be great. Many mutual fund investors use growth funds as investment vehicles to get exposure to good growth stocks. Whether you choose to invest in a growth-focused index fund or take the time to individually find stocks with high-growth potential, growth investing can help you reach your long-term financial goals.

If growth investing feels too risky for you, consider the value investing approach. Value investing looks more at whether a stock is attractively valued than at its future growth prospects, seeking to find out-of-favor companies that have had their share prices unfairly beaten down.

However, do note that Value Investing has been a laggard vs. growth investing over the past 2 decades.

Conclusion

Investing in growth stocks can be exciting. Beyond looking at just a few key financial metrics which I highlighted that one can use to screen for potential growth stock candidates, there are other traits of which makes a growth stock a GREAT one.

For example, the presence of economic moat, particularly having the most sought after “network effect”, something which I highlighted in this article: Finding great companies with network effect.  

This will be an article for another day.

In the meantime, investors who are looking to find new ideas for growth stocks can look to do their screening using both free and paid screening tools or follow some of the most well-known investors who specialize in growth stock investing.

The best growth stocks are typically those that have mass-consumer appeal while yet possessing strong economic moats such as a network effect which enhances their value proposition. However, finding such stocks are never a walk in the park. Investors might potentially need a relatively long investment horizon to benefit from these growth stocks.

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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.