Finance

Growth Investing Strategies That Work and Their Limits

Growth investing has been the focus of most stock pickers in the extended bull market that followed the 2008-2009 recession. That focus shifted dramatically in 2022 as markets turned down and investors dumped shares in growth-focused companies.

The tide seems to have turned for some growth stocks. This makes it the perfect time to look at what works for growth investing strategies and their possible limits.

Growth vs. Value

Many investors treat value investing as the opposite of growth investing. These investing styles are different, but I would argue that all growth investing is ultimately value investing as well. The difference is that the value calculation is based on future value instead of current value.

This emphasis on the future is what makes growth investing both so appealing and so difficult.

The appeal is that future growth can outsize any other type of gain. Early investors in Facebook, Amazon, or Telsa are good examples of this.

The difficulty is that the future is, by definition, unknowable. So any lofty projection for the future might hit a brick wall of unexpected problems.

How to Succeed at Growth Investing

To succeed at growth investing, you need to pick companies that will be the winners in the future. Here are a few ways you can increase your chances of finding giants in the making.

1. The Right Trend

I intentionally wrote “trend” and not “technology.” The trend can be a specific technology like smartphones, electric cars, or semiconductors. It can also be the trend toward large supermarkets: Walmart used to be a small company with explosive growth. Starbucks was a small coffee chain selling “overpriced” drinks.

The key here is to identify a powerful trend in the economy, usually something that people are happily throwing money at. This doesn’t have to be tech-focused.

The ideal target is a general sector that is growing aggressively and has access to plenty of capital. This means the companies you pick can grow both in market share AND together with the whole sector.

2. Unique Advantage

Once a good trend is found, you need to find a company in it with a definitive competitive advantage. That advantage can be unique technology, but it can also be a better business model and economy of scale (Walmart, Cosco), an oligopoly or monopoly (Visa & Mastercard), or an exceptional customer experience (Starbucks).

The point is that we already know the sector is growing extremely quickly. In that context, the company with a hard-to-replicate advantage will most likely win the competitive race.

This creates a so-called flywheel effect: the more it grows, the strongest its unique advantage gets, the more of the sector it dominates, and the quicker it grows. Rinse and repeat.

3. Build Expertise

Because explosive growth is usually supported by dramatic changes and disruptions, it can be hard to understand what is happening.

Investors who develop a true expert view of the sectors they are most interested in have a real advantage. That can be a unique insight into the technology or a deep understanding of the business model of the innovators driving the growth.

Being an expert or becoming one will give investors an edge against generalists, who often miss factors that can disrupt the industry and make previous financial models obsolete.

Price Still Matters

Growth investors are an optimistic bunch. They don’t fear the future; they wait for it eagerly. This optimistic nature can lead them astray.

It is very common for growth stocks to be priced at higher valuations than more stable companies. This makes sense, as cash flows growing 20%-30% per year should be priced in the company valuation.

This does not mean that ANY price is okay for growth stocks. Too optimistic a valuation can lead to a bubble, especially when the valuation is based on hype and unrealistic expectations. This is the most valid criticism of growth investing.

The best example was during the dot.com bubble, where some stocks of large companies (not startups) reached absurdly high valuations.

At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends.

That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate.

Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?

The CEO of Sun Microsystem explained it simply

Any company trading at more than 10 times revenues is probably grossly overvalued. The same is true of anything with a P/E ratio over 100 or a price-to-free-cash-flow ratio over 50.

This is not a new or tech-related phenomenon. In the 1970s, the “Nifty-Fifty” stocks were equally overpriced and experienced declines of up to 90% in the following decade.

I will also point out that it is not about the quality of the company. Mcdonald’s or Disney in the Nifty-Fifty were great growth companies. But at the prices they traded back then, they were terrible investments.

The problem is that, maybe, if everything goes right, the company multiplies by 10x its sales in a decade before slowing growth, something exceptional indeed. With a price-to-sales ratio of 10, the company’s current valuation already prices in such lofty expectations. Anything less can lead to a terrible crash. And success would mean no capital gain at all. The risk-reward ratio is just awful in such a situation.

I suspect some of the high flyers of this era, like Tesla, Moderna, or Nvidia, might be in the same situation. You can believe that Tesla is a great company and still recognize that it is too pricey to be a good stock pick anymore.

Building a Growth Portfolio

It is very rare that only one sector of the economy is growing. For example, could you guess which US stock produced the highest returns from 1990 to 1998? You would likely expect some tech stock of the time, like Microsoft, considering that this was the time of the dot.com bubble.

It was actually Veritas, an oil service firm based in Houston, with an astonishing 146% annualized returns. 1.5x every year; 12x in 8 years!

Growth investors should not too enamored with one specific sector or technology. The future is very hard to predict. Even the best growth investor in the world will make some wrong calls. Diversifying both individual stock picks and sectors will be key to reducing risk.

The winners of the 90s were not just in tech but also in oil, biotech, retail, and financials.

Diversification is also key to improving returns. Growth investing can bring exceptional results from just a few stock picks. This means that the total returns are often driven by less than 5%-10% of the whole portfolio.

Many successful investors over the last 20 years will probably have most of their total gains coming from a handful of positions: Nvidia, Amazon, Tesla, or Bitcoin, for example.

At the time, these were risky bets. Almost no one put massive hopes on a low-margin computer card maker, a money-losing bookshop, a manufacturer of self-igniting sports cars, and obscure lines of code with no real purpose.

These investments succeeded, but many other speculative ventures did not. Growth investors can’t expect to get every call right. The goal is to pick enough winners to outweigh the inevitable losers.

By diversifying and having many different investments, you are more likely to see your net catch the very rare fish able to go up x100 or x1000 in 10-20 years.

Conclusion

Growth investing can be a very successful strategy. It is also perfectly suited for tech enthusiasts and people with a tendency toward optimism and thinking out of the box.

Returns in a growth portfolio will most likely come for “moonshots” IF the portfolio is diversified enough. High concentration is likely the road to ruin for growth investors. Unlike value investing, there is not really any “margin of safety” to rely on here.

The other factor is to beware of bubbly valuation. It is easy to think that the stock that just did x20 will do another x10 soon. Instant millionaires are tempted to believe they are geniuses and ignore the role played by luck. The exponential curve always stops somewhere.

For this reason, it might be best for successful growth investors to know when to take out some gains. And to remember to never tie their identity to their stock picks.


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