Growth Investing Explained

Growth Investing: Explained.

I’ve been fortunate enough to work with some of the most successful growth investors in the world.

I’ve also learned how NOT to do it, but you don’t need me for that… just ask most investing YouTubers.

So today, I’m going to explain what growth investing actually IS… hint hint, it’s not a get-rich-quick scheme.

I’m also going to break down the 3 types of growth stocks and how they perform in different market environments. Then I’ll share some growth investing wisdom that I’ve picked up over the years, give you some historical perspective, explain what’s driving the current rally, and point you to a few of my favorite books in case you want to learn more.

Let’s start with what growth investing is, and is not.

Growth is simply a “style” of investing, with the other one being “value.” It’s not a get-rich quick scheme, it’s not only high-flying risky tech stocks, and it’s not really the opposite of value investing, although it’s sometimes portrayed that way. Recently I did a video comparing value and growth, which dives deeper into that, but here we’ll stay focused on growth.

Growth investors generally focus on companies that can “grow” faster than the market. Usually that refers to how fast they can grow their earnings, but people can also use revenue, sales per share, or many other metrics.

The main idea of growth investing is that in the long-run, earnings growth is the biggest driver of the upside potential in a stock. If you think about it fundamentally, that makes perfect sense. A cheap company can only go up in value so much before people will think it’s too expensive. But earnings… well earnings can grow essentially forever. A company that consistently grows decade after decade can, and usually WILL end up MANY times larger than it started.

EVERY style of investor cares about earnings, because a company will eventually go away without them, but growth investors SPECIFICALLY look for the companies that are growing earnings or revenues FASTER than most others.

Among growth companies, there certainly ARE some of those high flying tech stocks that people often think of when they think about growth stocks, but those are not the only kind.

I think of growth stocks in three buckets:

High-growth stocks, quality growth stocks, and cyclical growth stocks. These are not universally recognized terms, just how I think it’s easiest to break them down.

High-growth stocks are what most people think of when they think about growth stocks. These are companies that are growing fast, and often don’t even make a profit yet, but have big aspirations. Think… Netflix or Tesla in their early stages, when video streaming wasn’t a thing yet, and no one drove electric cars. We know the names of Netflix and Tesla because they ended up being successful. We don’t know the names of the THOUSANDS of companies just like them that didn’t make it. Finding the next Netflix or Tesla is a lot easier said than done, but high-growth ETFs and mutual funds are likely to have a few of them in there, along with a lot of future failures. These types of companies tend to be prone to booms and busts, especially in major hype cycles, which we’ll cover more in a bit.

The second category of growth stocks is quality growth stocks. I think of these as companies that offer solid above-market growth potential, but are not the kinds of companies that finfluencers will tout as being able to make you rich in 1 year. Often they have dominant positions in growing industries, like semiconductors or aerospace over the last 10 years. They’re usually profitable and don’t depend too much on the overall economic environment to be successful.

The third category is growth cyclicals. These are sort of a combination of two types of companies – growth companies and cyclical companies. They have above-average growth potential like most growth stocks, but they’re prone to periodic boom and bust cycles like cyclical stocks. An example of a cyclical stock would be an oil company. The long-term demand for oil is projected to grow slowly, and then eventually fall, so the long-term growth potential for oil companies is pretty limited… but if oil prices go negative like they did in 2020, you can get a pretty nice bounce off the bottom in the short-term. A growth cyclical is more like semiconductors. They power everything digital and are expected to grow faster than average over time, but they’re ALSO prone to cycles. In 2020 and 2021, everyone was stuck inside so they bought up a TON of digital gadgets that required semiconductors, like new computers. In response to the high demand, semiconductor companies ramped up production like crazy. But they ended up making too many and having to cut their prices, because by the time they finished making them, people had decided they didn’t want to do everything electronically anymore, they wanted to see people in person again. Semiconductor stocks boomed, then they busted, and now they’ve been booming again as they’ve gotten rid of all their extra supply and there’s a big new source of demand from AI.

High-growth stocks, quality growth stocks, and growth cyclicals all tend to behave differently in different market environments.

Whereas high-growth companies usually don’t do well in market downturns, the stability of quality growth companies often DOES help them hold up better than the market in downturns. As growth gets more scarce, the market places a premium on the few companies that CAN maintain their growth rates.

Like we saw with semiconductors, growth cyclicals often have their own industry-specific up and down cycles that may or may not align to the cycles of the broad economy.

While the things I mentioned above are GENERALLY true, it’s important to remember that which companies will do well in any given market environment, will ALWAYS depend on what’s driving the market THAT time.

2020 was a great example. You had lockdowns and supply chain issues that had major negative impacts on some companies, even QUALITY growth companies like airplane manufacturers that had multi-year backlogs of orders. On the other hand, a lot of risky high-growth companies that benefitted from the Work From Home trend like Zoom and Peleton, saw their growth rates AND stock prices skyrocket. In ANY recession… or any other market environment for that matter, the major factors that are driving the market up or down will determine which companies are the winners.

Next, let’s dive into 4 key lessons for growth investors.

First, don’t fight the fed. This is a lesson for ALL equity investors, but ESPECIALLY growth investors.

By definition, growth stocks are more impacted by interest rates than value stocks. The value of any stock is the present value of all its future cash flows. They’re discounted back to the present value at a rate determined by the risk-free interest rate.

So, for an oversimplified example of how this works, if a company is expected to earn $105, 1 year from now, and the interest rate is 5%, the company would be worth $100 today. It’s worth $100 because if you invested $100 and earned a 5% return, you’d have $105 in 1 year, and that’s what the company is projected to earn 1 year from now.

However, if the interest rate was only 1%, the company wouldn’t be worth $100 today, it would be worth $103.96. The value is HIGHER when interest rates are LOWER.

Of course, in reality, companies won’t just earn money for 1 year. When valuing a REAL company, you’d perform this same exercise to discount the future cash flow you expect it to earn 1yr from now, 2 years from now, and so forth and so on, back to their present values.

Higher interest rates reduce the value of future cash flows, and growth companies, by definition, get more of their value from future cash flows further out into the future. You know… because they’re growing faster.

For an example, look no further than 2022, as value, the red line, CRUSHED growth, the blue line, when the Fed started aggressively raising interest rates. That’s why growth investors should ALWAYS remember not to fight the fed.

Lesson #2 is beware of “this time is different” narratives. In the 1990s a bunch of the high-growth tech companies didn’t have any earnings so people couldn’t value them with the price-to-earnings ratio. But instead of saying… hmm… maybe having no earnings could become a problem, people said it was actually the P/E RATIO that was the problem, and started using the price/sales ratio instead. In hindsight, earnings DO matter and people thinking that internet stocks were somehow immune to that was a sign that the top of the really was near.

Another example came in the mid-2000s. For all of history you had to actually make money to pay your mortgage, but then all the sudden banks decided house prices could never go down so they started loaning millions of dollars to people who didn’t have jobs. In hindsight, house prices CAN go down, and people DO need an income to pay for them. Thinking that the risk had just magically gone away was a sign that the top of the rally was near. History doesn’t repeat itself, but if often rhymes, so when you hear someone saying this time is different, proceed with caution.

Lesson #3 is that trying to pick between growth and value stocks is a fool’s game for two reasons. First, in the words of Warren Buffett “there IS NO such thing as growth stocks or value stocks as Wall Street generally portrays them, as contrasting asset classes. Growth is part of the value equation.”

Second, growth and value stocks, as wall street potrays them, can go in and out of favor for long periods of time, so sticking to just one approach for your entire portfolio can be dangerous.

Lesson #4 is that no growth trend lasts forever.

·        In the early 1970s the “nifty fifty” stocks were blue chip companies that you could supposedly hold forever. Yet they became overvalued and most sold off 50+% in the downturn of 1973-74.

·        Small tech stocks became all the rage in the early 1980s, only to collapse a few years later.

·        Japanese stocks had an INCREDIBLE run in the 1980s, only to come crashing down hard. The Japanese stock market only just recently recovered back to the high it hit in 1989.

·        Tech stocks boomed again in the 90s, then busted in 2000, and didn’t recover for almost 20 years!

·        The BRICS fast-growing economies of Brazil, Russia, India, and China captured investors’ minds in the mid-2000s. But only China and India did well over the next decade, and now Russia’s stock market has gone to 0 for foreign investors and China’s is down over 50% from its peak.

·        Right now tech and AI are being hyped back up, leading just SEVEN stocks to drive two thirds of the S&P 500’s return in 2023. Tech has beaten EVERY other sector in the S&P 500 by at least 9% over the past 10 years. I’m not saying this growth rally CAN’T continue, but do you know how many times any sector has been the best over 10 years, and then the best again over the next 10 years? 0. It’s never happened.

·        How do you know when one of these growth cycles is nearing its end? I don’t think there’s an exact science to that, but for me, an indication is when everyone starts piling in. Sometimes that’s the last few months, more often it can last a few years longer, but once the FOMO money comes and it starts showing up on Wall Street Bets, or celebrities start hyping it up, to me that’s a signal that a rally is getting a bit long in the tooth. “This time is different” arguments also make me nervous for the top.

So is that where we are today?

The current growth rally has been one of the longest ever and it’s been powered by 4 key drivers.

In my mind, it all started when the first iPhone was launched in 2007. By 2023 hundreds of millions of Americans and over 6 billion people globally had a smart phone.

Then, 4G internet came out for mobile phones in 2009.

These two advancements powered an entire industry of companies from social media to food delivery to e-commerce to semiconductors. Pretty much all of these were growth companies that were capturing VAST new markets.

The third driver of the growth rally was interest rates. The Federal Reserve lowered interest rates to zero in 2008, and then when that wasn’t enough to save the economy, they embarked on a program called quantitative easing. Essentially, they bought a ton of long-term treasury and mortgage bonds to artificially suppress long-term interest rates and encourage more long-term investment. Well, it worked. All the way until 2022, we had artificially low rates, which made it unusually cheap for early-stage growth companies to borrow money. Not only did that boost their growth rates, but it also boosted their valuations, as I explained earlier. Lower rates raise the value of faster-growing companies more than slower-growing companies.

It seemed like the growth rally might be coming to an end in 2022 when interest rates started rising and growth stocks sold off sharply, but 2023 was a different story.

That’s where we get to the fourth driver of the growth rally, AI. Optimism surrounding AI has provided a second wind for a lot of growth stocks, specifically the big tech companies.

Now the question is: Will AI power growth stocks ahead for another generation, or are we in a period of over-hype like the internet bubble in the 1990s? After all, the internet DID change everything in the long run, but that didn’t mean the internet stocks were good investments from 2000-2002. They got DECIMATED. Let me know in the comments if you want me to do a video on how long I think the AI and tech rally can continue. I don’t have a crystal ball, but I’m happy to share how I’ve been thinking about it if people are interested.

For people who want to learn more about growth investing, two books I learned a lot from were “One up on Wall Street” by Peter Lynch and “Common Stocks and Uncommon Profits” by Phillip Fisher.

Peter Lynch is widely considered to be one of the greatest investors of all-time. His Fidelity Magellan fund beat the market 11 out of the 13 years that he ran it, and I think of him as one of the pioneers of the GARP approach. That’s growth at a reasonable price, the idea that you want to buy companies that are growing, but you don’t want to overpay for them.

Phillip Fisher is known as one of the fathers of growth investing, along with T. Rowe Price. He’s also considered to be one of the greatest investors of all time.

I’ll leave it to the books to teach you their philosophies in-depth, but there’s one comment I’ll make that applies to Peter Lynch, Phillip Fisher, Warren Buffett, and pretty much every other all-time great investor. They had a long-term focus and were NOT thinking about which company would make them rich in 1 year. That’s a fool’s game, and I would suggest you think twice before playing.