What is the best way to spot the sort of once-in-a-generation growth shares that could set my portfolio on fire? Different investors use a variety of approaches. Here are three things I look for when hunting for growth shares with exceptional prospects.
1. Back the strongest horse, not the race
Identifying a promising industry is one thing, whether it is lithium mining or semiconductors. But choosing the right company to benefit from the industry growth is a much more challenging decision, in my view. There may be dozens of companies with stories about how they plan to exploit a promising technology or market opportunity.
Choosing the right one can be crucial in terms of future returns: some will fall, many may be also-rans, but only one or two might go on to have the sort of commanding position seen with Alphabet in search or Paypal in payment processing.
That is why I think it is always worth taking time to decide which company has the strongest competitive advantage in an emerging business area. Getting on the strongest horse seems like the easiest way to win a race. Great growth shares should benefit from a clear competitive advantage — just being in the right industry may help, but it is not enough.
2. Profits matter
Maybe a company does not have a plan to make profits soon. But ultimately, company valuations rest on a firm’s ability to generate earnings. If a business remains loss-making forever, at some point its share price will likely suffer in consequence.
So, when looking at growth shares I might buy for my portfolio, I consider whether there could be a viable business model for the industry as a whole that would allow it to be consistently and handsomely profitable, even if it may not come to pass for many years. That is one reason I do not own shares in food delivery companies like Deliveroo. I struggle to see a viable business model where low-cost food items can be delivered on demand to high volumes of individual customers while generating big profits.
3. Timing the moment
Amazon has been an incredible growth share. Not only that, I reckon the company still has enormous future growth prospects. Last year, for example, it grew sales by more than 20%.
But if I bought Amazon shares a year ago, my investment value would now have shrunk by 25%. That underlines an important principle about growth shares: they do not offer good value at the wrong price. That should be obvious, as valuation is a critical investing concept many shareholders understand well when it comes to more established companies. But it can be easy to get sloppy on valuation discipline when it comes to growth stories.
Buying a growth share too late can mean that the positive prospects are all priced in. But when buying it too early, there is the risk that the promising growth story will fade with time. That is why I try to look for growth shares at a point when the business model is already proven, but the potential scale of the industry remains far from tapped.