Growth Investing

Growth investing is an investment strategy that deliberately overweights shares in companies whose revenue and earnings are expanding, or are expected to, accepting a higher price relative to current results in exchange for the expected future ones. It is the counterpart of value investing, and FINRA teaches the two together: "a common investment strategy for picking stocks is to focus on either growth or value stocks, or to seek a mixture of the two since their returns tend to follow a cycle of strength and weakness."

A naming note, because two of our pages cover one subject. "Growth stock" names the classification and "growth investing" names the act of building a portfolio around it. The stock page covers what the label means, where the return is supposed to come from, and how the SEC's fund names rule handles the absence of any agreed definition. This page covers what running the strategy involves.

The single most useful thing to understand about this strategy is that the return has two independent conditions. The first is the obvious one: the company has to expand as expected. The second is easy to miss: the market has to keep valuing that expansion at a similar multiple of earnings. A company can deliver everything it promised and still lose its holder money, if the price the market is willing to pay for each dollar of those earnings falls at the same time. That is not a rare event. The multiple attached to future expansion is a statement about optimism, and optimism moves for reasons that have nothing to do with any individual company's results, including the general level of interest rates.

The consequence is that "the company did well" and "the investment did well" come apart more often here than elsewhere. In the value case the buyer is paying little for results already reported, so there is less optimism embedded in the price to be withdrawn. In the growth case the price is substantially a forecast, and the buyer is exposed to that forecast being revised, not only to it being missed. This is the mechanism behind the observation on the growth stock page that these shares tend to be more volatile: a price built out of expectations moves whenever the expectations move.

Selection is where the strategy quietly makes decisions the investor did not make. Whichever screen defines "growth" is also, without saying so, deciding which industries the portfolio ends up in, because the companies expanding fastest at any moment tend to cluster in whichever sectors are being reshaped at that moment. So a growth allocation is frequently a sector position wearing a style label. Whether that concentration is acceptable is a decision worth making on purpose rather than inheriting from a screen, and it is the reason the size of a growth allocation matters as much as the decision to have one.

The cycle FINRA describes is the reason a stretch of underperformance proves nothing either way. If the relative fortunes of growth and value swing, then any few years of results is a sample from one part of a swing. A period in which growth trounces everything is not evidence the strategy is better, and a period in which it lags is not evidence it is broken. FINRA's inclusion of "a mixture of the two" as a normal answer follows from the same observation: holding both removes the need to be right about which part of the cycle is next.

Where this page stops. What makes a share a growth stock, the fact that no regulator defines the term, and the SEC fund names rule that requires a fund using the word to write down and stand behind its own definition are all covered with the classification. The valuation ratio most often used to describe how much is being paid for current earnings has its own page, as does the question of whether an active tilt of any kind is worth making.

An investor decides which measures define expansion, applies them to a universe of companies, and holds the ones that pass, directly or through a fund built on the same screen. The holding pays off if the companies expand and the market continues to price that expansion generously; it is rebuilt periodically as companies enter and leave the screen.

A hypothetical example of the two conditions coming apart. Priya buys shares in a company at $120 when it is earning $3.00 a share, so she is paying forty times earnings. Three years later the company has done exactly what was expected: earnings have doubled to $6.00 a share.

If the market still pays forty times earnings, the shares are worth 40 × $6.00 = $240, and Priya has doubled her money. If the market has cooled and now pays twenty-five times, the shares are worth 25 × $6.00 = $150, a gain of $30 a share, or 25% over three years, on a business that doubled its earnings. And if the market pays fifteen times, the shares are worth 15 × $6.00 = $90, and Priya has lost $30 a share despite being entirely right about the company.

Nothing in that example required the business to disappoint. The variable that moved was what other buyers were willing to pay, which is the exposure a high purchase multiple creates and the reason expansion alone does not settle the outcome. All figures are illustrative.

Pros

• Expansion is the only route by which a company becomes materially larger, so a strategy pointed at it is pointed at a real source of long-run return.
• Companies that retain their earnings produce no distribution to be taxed along the way, so in a taxable account the timing of the tax is the holder's.
• The exposure is available cheaply through a fund, so the strategy does not require picking individual companies.
• FINRA treats a mixture of growth and value as a recognized approach, so this need not be an all-or-nothing position.

Cons

• Two things have to go right rather than one: the expansion has to arrive and the market has to keep paying a high multiple for it.
• Being right about the company is not enough. A falling multiple can produce a loss on a business that performed exactly as expected.
• A growth screen tends to concentrate the portfolio in whichever sectors are expanding fastest, which is a sector position the investor did not explicitly choose.
• The whole return depends on a later buyer paying more, with nothing arriving as cash in the meantime.
• There is no official definition, so two funds using the word can hold different companies and neither is mislabeled.
• A broad market fund already holds these companies, so the strategy is an active decision that needs an active reason.