Growth investing explained

The appeal of growth investing is obvious. Find the next great company before everyone else does and hold on for years. That is the dream, at least. The reality is more complicated, and understanding the difference between the two is one of the most useful things a new investor can learn.

Growth investing is a strategy built around finding companies expected to grow their revenues and earnings faster than the market average. Where a value investor looks for companies trading cheaply relative to what they already earn, a growth investor is willing to pay a premium today in the expectation of much larger earnings in the future. The bet is not on what a company is worth now but on what it will be worth in five or ten years’ time.

The companies that attract growth investors share certain characteristics. They are typically expanding fast, either by winning customers in an existing market or by opening up entirely new ones. Revenue growth rates of 20 or 30 per cent a year set them apart from the steady but unspectacular performers that fill most major indices. They tend to reinvest everything they earn back into the business rather than paying dividends, because the opportunity ahead of them is judged to be worth more than handing cash back to shareholders. Profitability often comes later, sometimes much later.

In the UK market, companies that have attracted growth investors over the years include names like Rightmove, which built a near-monopoly in online property listings, and JD Sports, which expanded from a single market stall in Bury into a business operating across Europe and the United States. In technology, companies like Sage Group and Aveva grew at rates that far outpaced the wider economy. None of these were guaranteed bets when growth investors first noticed them. What united them was a combination of a large addressable market, a clear competitive advantage and management willing to invest aggressively to take market share.

Identifying growth companies before the crowd is the hard part. Most investors screen for revenue growth rates, looking for companies that have grown sales by at least 15 to 20 per cent a year over several consecutive periods. Consistency matters more than a single exceptional year. Earnings growth is just as important, but it needs careful reading. Many genuine growth companies report losses for years before turning profitable. What investors look for instead is evidence that the underlying economics work at the individual customer level, even if the company as a whole is spending heavily to acquire those customers. Gross margin, the percentage of revenue left after direct costs, is often a better indicator of quality than net profit at this stage.

The size of the opportunity matters too. A company growing quickly in a small or shrinking market will eventually run into a ceiling, whereas one at the early stages of a genuinely large and expanding opportunity has the runway to compound at high rates for many years. This is often described as the total addressable market, and while the term gets overused in investor presentations, the underlying concept is sound. A business that has captured 2 per cent of a global market has a very different growth profile from one that has already saturated its home territory.

Growth investing carries real risks, and they are worth understanding clearly before committing money to any individual company. The most obvious is valuation. Because growth investors are paying for future earnings rather than current ones, valuations can stretch to levels that seem hard to justify on traditional measures. A company trading on a price-to-earnings ratio of 50 or 80 is not unusual in the growth space. The problem is that any disappointment, a missed revenue target, a slowdown in customer growth, a competitor taking market share, can send the share price down sharply, because the entire investment case rested on a high-growth future that has now been called into question.

This happened on a large scale in 2022 when rising interest rates caused a broad repricing of high-growth stocks globally. Companies that had been valued on the assumption of strong growth for decades found that higher interest rates made that distant future cash flow worth considerably less in today’s money. Many growth stocks fell 50 or 60 per cent or more from their peaks in a matter of months. Investors who had bought at the top and held a concentrated position in high-growth names absorbed serious losses.

The other risk is simply being wrong about the company. Growth investing requires a judgement about the future that is inherently uncertain. Companies that look like category-defining winners at one point often face unexpected competition, regulatory challenges or shifts in consumer behaviour that upend the original thesis. Ocado is a reasonable UK example: long described as a technology business reinventing grocery delivery, it has consistently disappointed investors who bought in at elevated valuations expecting rapid international expansion to materialise faster than it has.

Diversification helps manage some of this. Owning a basket of growth companies rather than concentrating in one or two means that the winners, which in growth investing can rise by many multiples, have a chance to more than offset the losers. Many successful growth investors accept that the majority of their picks will produce mediocre returns, but a small number will be exceptional, and the overall portfolio reflects that asymmetry. The maths of growth investing reward patience and breadth.

For UK investors, growth stocks can be found across the market, but AIM has historically been the home of many earlier-stage growth companies. The lighter regulatory requirements make it accessible for smaller businesses, though liquidity can be thin and the risks are higher than in the main market. The FTSE 100 contains mature growth companies, but genuinely fast-growing opportunities are more likely to be found in the mid-cap space or beyond.

Growth investing is not the same as speculating, though the line can blur when valuations get extreme. The discipline lies in the quality of the original analysis, the patience to hold through volatility and the intellectual honesty to reassess the thesis when the facts change. The ambition of finding the next Rightmove or JD Sports before the rest of the market notices is not unrealistic, but it requires genuine work, a long time horizon and the willingness to be wrong more often than you are right.

TL;DR — the short version

• Growth investing means buying companies expected to grow revenues and earnings faster than average, paying a premium today for their future potential.
• Growth companies typically reinvest profits rather than paying dividends, because expanding the business is judged to be the better use of capital.
• To identify growth candidates, look for consistent revenue growth over several years, strong gross margins and a large market opportunity still ahead of them.
• The main risk is valuation: growth stocks price in a rosy future, and any disappointment can trigger sharp share price falls.
• Rising interest rates, as seen in 2022, can hit growth stocks hard by reducing the present value of earnings that are years away.
• Spreading your money across several growth companies rather than concentrating in one or two helps offset the inevitable losers with the occasional exceptional winner.

Disclaimer: The value of investments can go down as well as up, and you may get back less than you invest. This article is for informational and educational purposes only and does not constitute financial advice. Always do your own research and consider seeking independent advice before making any investment decision.

Nothing in this article is financial advice. Tax rules change frequently. Check the current ISA allowance, CGT exemption and relevant rules on HMRC’s website or consult a qualified financial adviser for your specific situation.

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This article is for informational purposes only and does not constitute financial advice. Investment values can go down as well as up. Always do your own research before making any financial decisions.