When I’m looking for the best growth stocks to buy for my portfolio, I tend to focus on five key factors. Here they are, in no particular order:
1. Founder-led companies
Founders tend to have ‘skin in the game‘, often owning a significant portion of shares in the company. They are also able to continue the company’s culture and mission on which it was founded.
2. Strong revenue growth
Companies that haven’t yet shown a profit can be some of the best growth stocks around. This differs from value investing, where generally one would prefer a profitable company. Companies undergoing rapid growth might forgo a profit now in return for stronger revenue growth. By investing in the business, companies can become larger. Then once it has completed its rapid growth stage, it can become a more mature, profitable company.
3. Disruptive companies
The best growth stocks can often be found from companies that are potentially shaking up the industry. It could be from a new technology, or a new business model. For instance, Amazon started changing the way many people shop. Rapid growth can come from companies making big changes. Of course, it takes risk to be disruptive and not all companies will make it.
4. Strong economic moats
The best growth stocks tend to have some form of moat. This could be said for value stocks too, in my opinion. Warren Buffett popularised the need for an economic moat. It’s an advantage a company has that prevents competitors from taking market share. A moat might be in the form of a strong brand name like Nike, or a network that would be difficult to replicate, like Facebook. Without a strong moat, even the best growth stocks might not be sustainable over the long term.
5. Total addressable market
Often one of the first steps when starting a new business is to identify the total addressable market (TAM). Also called the total available market, this is a term that identifies the total revenue opportunity for a company or product. The best growth stocks have an extremely large TAM, in my opinion. It’s a long runway for future growth that provides ample opportunity to build a larger business. For instance, in a world shifting to electric vehicles, some might say that Tesla has a large TAM. Competition is a risk to growth companies, but there may be enough space in the market for several competitors if the TAM is large enough.
The risks to growth stocks
Growth stocks are not without risk. In rapidly changing markets, growth stocks can be more volatile. Although they can perform well in bull markets, they can also decline the most in bear markets. Large swings in price are not uncommon, and investors of growth stocks should be aware.
In general, they tend not to provide much in the way of dividends as they focus on reinvesting cash into growing the business. In companies that provide no dividend, shareholders receive no income and thus rely totally on share price appreciation.
Growth stocks tend to look expensive on traditional valuation metrics such as the price-to-earnings (P/E) ratio. In growth stocks, investors can be willing to pay for this higher valuation as they might expect the earnings to grow rapidly.