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Investor tracks a stock on a digital graphGrowth stocks are sometimes seen as the holy grail of investing. Many investors hope to find them; many traders promise to know them already. Finding a growth stock can help your portfolio gain years of value in a single trade, but guessing wrong on a growth stock can wipe that money out just as quickly. It is recommended that you seek the guidance of a financial advisor as you navigate this terrain to help you make the right decisions. Here is what to know about growth stock investing, including the dangers you should be aware of.

What Are Growth Stocks?

A growth stock is any one that grows more quickly than either shares of other corporations in the same industry or the marketplace at large. For example, if the S&P 500 gains 10% in a given year and ABC Corp.’s shares grow by 15%, we would consider ABC Corp. a growth stock. It would have beaten the market. Analysts may also flag a growth stock if they expect it will beat the market, meaning that this term can reflect either actualized or anticipated gains.

The term “growth stock” only refers to a stock’s price, not necessarily other forms of value, such as dividends. Growth stock investors make their money off capital appreciation, by  selling their stocks for a price that beats what they would have made investing in the market at large. As a result, a growth stock is based on the asset’s percentage gain in price rather than its absolute price increase. The question when assessing a growth stock is: How much did its share price increase, and how did that compare to the market at large?

Or, in other words, can this stock beat the market?

How to Identify Growth Stocks

When you’re looking for a growth stock you’re essentially trying to find a stock that the market as a whole has not discovered yet, otherwise the share price already would have gone up and your opportunities for growth would be gone. This means that technical analysis is unlikely to be your friend here. The stock’s historic pricing data is valuable information for sure, but most likely this information has already been priced into the share’s current value. Of course there’s a chance that the market might just be wrong, that other traders missed something in the technical data. That happens sometime but not often.

You’re more likely to have success by looking at the fundamentals of the underlying company and taking a bet that other investors did not. An excellent place to start is by researching industries in general that have historically beaten the market at large. For example, over the past 10 years both the health care and technology sectors have tended to do better than the S&P 500 or the Dow Jones Industrial Average. This means that companies within these industries often themselves do better than the market overall, making them a good place to look.

From there, you are searching for a company that is poised to have an above-average year. As a result you’re looking for indicators of an upcoming event or corporate behavior that would show that the business is poised for growth.

Following are marks of growth stocks – though not every growth stock will display each of these features:

High P/E ratio

A high price-to-earnings ratio means a high stock price compared to the earnings of the underlying company, which generally indicates that investors seeking growth-oriented equities are willing to pay a current premium because they expect greater earnings and therefore a higher share priceto come.

Increased funding for research, staffing, equipment, land

This kind of funding can actually push down a company’s stock price, as profits get diverted away from rewarding shareholders, but it can also mean potentially good things in the future. If the company has invested in expanding its business down the line, it can mean significant growth should that expansion pay off.

New product lines, services or markets

When a company launches a new product or service or enters a new marketplace it can often see substantial growth resulting from the new revenue stream. Be careful, though. When you’re investing based on a specific new product launch the rest of the market already knows about this and may have priced it into the stock already.

Small capitalization

Companies with small or low capitalization can sometimes grow more easily, since a smaller change in price translates into a larger percentile change in value. But beware, because the same holds true in reverse. It only takes a $1 loss for a $2 stock to wipe out half your investment.

Higher volatility

By nature, growth stocks tend to be riskier because they’re more volatile. If a company is on its way up then, it can be harder to gauge how quickly growth will happen or if it will happen at all. At a minimum, volatility indicates the shares are getting lots of attention, and that could be a red flag for investors seeking growth.

Less likely to pay dividends

One key characteristic of growth stocks is that they may be less likely to hand out dividends to investors – or at least less likely to increase dividends. Instead, these companies sometimes take any profits and reinvest them for growth.

Strong or surging retail sales

Pay attention to your own habits as a consumer, the articles you read online and the trends you see day to day. What products do you buy more often today than you once did? Are there any retailers that are suddenly just everywhere? Do you find that for some reason you just can’t escape a given publicly traded brand? These can all be indicators of a suddenly strong company.

Looking for a growth stock is an art not a science, and like all such ventures it can go wrong. Make sure that you trade growth stocks only with the speculative assets section of your portfolio. There’s a lot of money to be made by getting your stock picks right, but there’s a lot of money to lose by getting them wrong.

How to Invest in Growth Stocks

Carefully.

The three most important things to understand about a growth stock are, in order:

  • Everyone is trying to beat the market.
  • Many traders claim to know which stocks will beat the market.
  • Almost no one can consistently beat the market.

The point here is that the allure of a growth stock is its potential to outperform the stock market. In functional terms, if you were to invest in this stock you would make more money than if you put that same amount into an S&P 500 index fund?

Just keep in mind that every other single active investor in the marketplace is also looking for those same results. For a hedge fund manager or a professional trader on Wall Street, finding a stock that can beat the market by even a fraction of a percent can be worth a fortune.

The upshot is a constant churn of activity as investors seek stocks likely to do particularly well. Every time someone identifies a likely growth stock they buy in, which causes that stock’s price to rise. This in turn makes growth both less likely and more difficult. For example, at $10 if a stock’s price increases by $1 than it has achieved 10% growth. However, if that same stock is priced at $12 per share, a $1 price increase will only translate to 8.3% growth. Once the share price rises too far investors begin to sell off and book their gains, pushing prices right back down.

This bidding process happens billions of times every day.

The Bottom Line

"CAUTION" road signInvesting successfully in a growth stock is not impossible. However, it is important to understand features of a genuine growth stock, the dangers inherent in trying to pick growth stocks and why few stocks ever consistently beat the market. By the time a stock looks hot and poised for growth, it’s usually because professional investors – or their algorithms – have already discovered it and begun buying it up. This means that you are far more likely to “buy high,” purchasing the stock at an elevated price that won’t return much, if any, value. In fact, there is a significant risk that growth stocks might have already gotten overvalued, meaning that they could soon decline and expose you to substantial losses.

Tips for Investing

  • Investing shouldn’t be a gamble. While it’s exciting to find a new growth stock or the next big investment, in the long run what you really need is sound advice from an experienced financial advisor. Finding one doesn’t have to be difficult. SmartAsset’s free tool can match you with a financial advisor in your area in just a few minutes. If you’re ready, get started now.
  • Growth stocks can be a terrific segment of your portfolio, but it’s crucial that you balance them properly. One way to do that is with value stocks. Also, before making any strategic moves, make sure you understand the basics of asset allocation.

Photo credit: ©iStock.com/marchmeena29, ©iStock.com/MicroStockHub, ©iStock.com/scibak

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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