In this article you will find the essentials to understand how to think about growth stock investing. They form the basis of my investment framework.
First, let's discuss what growth stocks are, then why they are my favourite investments and how they compare to the market as a whole. Then we'll go over what it will look like and what you should prepare for when you choose to invest in them.
Growth stocks are companies, often relatively young ones, that grow at 20 to 25% a year (or more even). If chosen correctly, this is where you will find companies that will go 10-40x or even 100x if you wait long enough. One or two of these in your portfolio should be enough for most people to completely change your financial life and to offset losses from other investments that you will inevitably make.
They can be found anywhere and don't have to be in a fast-growing industry. Or any particular industry, really. When you study history, you will find they exist among retailers, beverage makers, food processors, tech firms and many other kinds too.
What they have in common is that they have enough room to expand. That means it helps if they are still relatively small in terms of market cap. What drives their stock to go up over time is growth in sales, in margin expansion and the multiple the market puts on the stock.
Chris Mayer, the author of the book 100 Baggers, has written about his research of finding stocks that became 100 baggers. Those are stocks that have gone up 100-fold, turning an initial investment of $10,000 into $1 million. He looked at all companies that returned at least 100 to 1 during 1962-2014 and found out there were 365 of them that passed this threshold. What he found was that most of these companies looked expensively priced when based on past results alone. This is an incredibly important lesson. To do well in growth stock investing, you have to train your mind to look for ideas that could become big and to think of where a company could be some years from now rather than where they are today. That can be in a large addressable market, but also in a niche market that a company knows how to dominate. The key is to think in long-term opportunities.
As much as I love investing in them, it is worth noting that they come with risk and volatility. Often the two are used interchangeably, but I see risk as the likeliness of losing (a large part of) your money while volatility being huge swings in stock price, both up and down.
The risk comes from the fact that many fast growing companies are still small, new companies that are often too fast, too furious in achieving their goals while often being underfinanced. According to the Bureau of Labor Statistics, in the US, nearly half of all startup businesses won't make it until their 5th year and only 25% of them make it until their 15th anniversary.
When fast growers run out of steam and turn into slow growers, Wall Street beats down the stock accordingly, resulting in a stock falling by 50 or even 70% sometimes. But as long as they can keep it up, fast growing companies are the big winners in the stock market. That's why you need to keep tabs on the companies you invest in as the story may not play out as you initially imagined.
Growth stocks are also very volatile. When the market goes up, growth stocks tend to go up even higher. When the market goes down, growth stocks go down too, only much more. It's inherent to growth stock investing and you have to get comfortable to the idea that they may drop by a lot in the short run. If your response would be to sell them when they are down 30 or even 50%, you probably should steer clear from them. What many people tend to forget is that these stocks show swings of similar magnitude to the upside too. If you want outsized returns in the stock market, this is your price of admission.
The best thing to do is prepare for it mentally before it happens. Think of what you would do when your portfolio goes down by 30% or more. Would you be able to sit still and wait till the storm is over? Or, better still, if the stock price goes down and you see no reason in the business' fundamentals, could you add more to your position to take advantage of the situation? This is how money is being made. And while it sounds easy, in reality it often isn't when it happens to your own money.
That's because we're loss averse. A 20% drop hurts more than a 20% gain will bring us joy. That's why it's important to build in some safeguards into your investment strategy to protect yourself against your own emotions. The why I do this is through portfolio allocation, dollar-cost-averaging and a by keeping a long-term mindset while monitoring the company closely to see if the story is still playing out.
What helps is to not try and chase returns. It may be very tempting to switch course when you see other stocks outcompeting your own. Shifting between different strategies depending on what the market is doing is a sure way to losing your money. If your portfolio is underperforming the market for short periods like a year or so, that shouldn't worry you as long as you've done your homework. No one will know what will happen in a few months or even a year from now, even though many people out there will want to make you believe that they do. And what's a year when you're playing the long game? Even the best investors lag the market 30-40% of the time. If you're not ready for that, then growth stock investing probably isn't for you. But if you can deal with that, read on.
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