Investors devise various stock picking techniques to cherry-pick company’s shares in order to maximize gains and minimize risk exposure. One of the most popular investing strategies implied by investors is to buy growth stocks i.e. stocks of those companies which have higher anticipated earnings potential in future. For instance- investing in an Apple or Starbucks or probably Alphabet shares.
This strategy can be highly remunerative. The main reason for this strategy to work is that stocks are valued at a multiple of their earnings. Consequently, if a company’s income increases, then its share prices also expected to increase.
Growth Stocks: Growth stocks belong to companies that generate considerable and viable positive profits at a much faster rate than the average company within the same industry. A growth company has a competitive advantage over the competitors in terms of introducing new product, service, pursuing overseas expansion, developing a business model.
Characteristics of the growth stocks: Here are some characteristics which are common in growth stocks.
- Faster growth: Growth stocks usually generate remarkable and sustainable positive cash flow, revenue, profits, at a much faster rate than the average company within the same industry. Most importantly, investors believe the company’s growth rate will continue.
- Premium Valuation: By traditional Valuation metrics many of the growth stocks will look overpriced. Some of the valuation metrics are P/E ratio, P/B RATIO, P/S ratio, and more.
The investors are ready to pay for growth stock by believing that the company will continuously show rapid growth in the future. If that happens, then there are chances that the share price will also shoot up and it will lead to market-beating returns.
- Dividends: Usually, growth companies reinvest their profits in their capital projects to drive even more growth. That’s the reason most growth companies do not issue any dividends.
Risks involved in Growth Stocks: There are three significant risks that investors must assume while buying growth stock companies:
- High Valuation: Investors ready to pay a high valuation to buy a growth company, anticipate the company to show rapid growth for many years to come. The high valuations represent high expectations for the business, and erratically those expectations become so high that it becomes unimaginable for a company to achieve, and whenever company posts the results which disappoint the market, then it creates panics and due to that many investors choose to exit from the stock which sends share price into a tailspin.
- High Volatility: Growth stocks usually tend to trade at a premium valuation, and they are prone to big price swings. During bull markets, growth stocks prices tend to rise rapidly, and they beat the market returns. Inversely, growth stocks will quickly decline in bear markets due to risks involvement.
- Execution Risk: On paper business plans always sound good, but in the real-world executions of business plans are not possible.
- Cyclical: In the stock market, mostly shares trades in cycles. If investors buy growth stocks when the market starts shifting its attention somewhere else, then they can underperform, maybe for years at a time.
Investing in growth stocks can be highly advantageous given investors prudently make rational stock picking decisions. However, this strategy is not suitable for everyone as it bears significant risks as well.
Hence investors should adopt diversified investment strategies based on their fundamental & economic analysis, market understanding and well as risk tolerance capacity.
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