The term “high growth” is a description that has used ubiquitously in the financial media, but was does the term mean and what are the characteristics of high growth stocks?

Definition

A definition of a growth stock is one where investors see higher growth potential compared to the average market. As investors believe the company will grow significantly in the future, they are willing to pay an expensive price for the stock, which causes the share price to further accelerate.

Characteristics

• A growth stock usually is expensive. This means that the share price does not reflect the intrinsic value of the company. The price to earnings ratio (P/E ratio) is usually very high compared to the market average
• High growth stocks usually don’t pay dividends. The earnings from these types of companies are reinvested back into the company so it can expand further
• These companies have a record of high earnings growth (EPS growth)
• Their growth rate is usually 10%+ where larger companies have a 5-7% growth rate
• Growth stocks can have higher share price appreciation compared to the broader market

What are the risks?

• These stocks can be riskier than value stocks. When there is bad news, these stocks may drop a lot more and a lot quicker than blue chip stocks because they are already quite expensive. However, it can also be argued that “value” stocks are lower quality and therefore inherently riskier to own than a “quality” growth stock.
• Some growth stocks do not make money as yet. Although their earnings are growing, the expenses are higher than the revenue they are generating. Investors believe these companies will eventually make money and are willing to pay an expensive stock price for it. However, if these companies don’t end up making a profit then they will collapse.
• Liquidity may be low so it may be hard for the investor to get out of a growth stock at a good price
• Share price of growth stock may reflect the exuberance of investors. This may mean that a bubble could be forming as more investors are buying into the stock because they see the share price going up and fear they are missing out on an opportunity.

When is a good time to buy a high growth stock?

Growth stocks perform the best in periods of strong economic growth or bull markets. Value stocks perform better in economically weak periods. When the economy is shaky, investors seek stable investments so they tend to invest in value stocks as they are safer investments than some growth stocks which could be very volatile.

Who are growth stocks suitable for?

Investors who have a high-risk appetite will find growth stocks suitable. These stocks can be riskier but they can also generate higher returns than blue chip stocks if you have a longer-term investing horizon. As many of these companies are new and re-investing earnings back into the company, then dividends are usually not paid to investors. Hence these stocks are not suitable for investors looking for income in the short term.

Lauren Hua is a private client adviser at Fairmont Equities.  

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