Growth Investing 101

In many ways, growth investing is the inverse of value investing. Value investing is about comparing a company's intrinsic worth to its market price. Value investors tend to flock to companies that have low multiples or sectors that are out of favor.

Opportunities

In contrast, growth investing is less about what a company is worth today and more about what it's going to be worth many years from now. Of course, this means making assumptions about the economy, the total size of the company's potential market, and the company's ability to execute. There are more upside and more downside. Typically, value investors are repelled by growth stocks due to their high multiples. However if a growth stock can execute, then it can realize these high multiples.

For example, Facebook (Nasdaq: FB) went public with a price to sales in the four digits and a negative price to earnings ratio, because it was losing money. This was because the company was focusing on growing its user base, and the amount of time spent on the platform rather than monetization. At some point, the company shifted its focus more towards monetization, and it has been able to steadily increase the amount of money it makes per user by delivering targeted ads. Today, its forward price to earnings ratio is 25 which is reasonable for a company growing revenues 20% with 80% gross margins.

Pitfalls

So growth investors can make spectacular returns when they can a stock that can successfully execute. However, the high multiples also mean that there's significantly more downside if a company fails to execute. This can be due to management making mistakes, competitors entering the market and forcing margins to drop, or economic conditions turning lousy. Often, an earnings miss or two can also lead to the stock being dumped as growth investors flee, and the price keeps dropping until it becomes attractive to value investors.

Optimal Conditions

In some ways, recent economic conditions have been optimal for growth stocks. Overall economic growth and interest rates have been depressed. However, growth has been positive, and overall metrics like retail spending and incomes are increasing but just not at a trajectory that would trigger inflation and lead to interest rates moving higher.

This makes companies growing at above-average rates even more attractive which leads to even higher multiples. In a sense, it's a reflexive relationship as many growth stocks with high stock prices can use their high valuations to keep growing and gain more market share.

Conversely, growth stocks could be negatively affected if economic growth picks up which would lead to more economically-connected industries like cyclical, commodities, and financials. It could also be hurt by a prolonged period of economic weakness which would lead to multiple compression, and investors sentiment becoming more pessimistic.