Today we’ll be talking about Growth Investing. What it is, how it works, examples of growth investments and, most importantly, how you can utilise the growth investing methodology in order to improve your portfolio performance.
I hope you enjoy reading and, as always, let me know any questions or comments below in the comments section.
Table of Contents
- The 3 main investment types
- What is Growth Investing
- A theoretical example
- Important KPIs for Growth Investing
- Total Equity
- When to buy and when to sell when Growth Investing
- Examples of Growth Investing
- How to find opportunities for Growth Investing
- 1. Use a stock screener
- 2. Get more information for the stock
- 3. Pull all information together and make an informed investment decision
The 3 main investment types
There are 3 main investment types, which I will elaborate further on this blog: Value Investing, Growth Investing and Income Investing.
All 3 have their place in a well thought after portfolio. There is no best and worst type, but all 3 have the ability to create tremendous returns if done right.
How to distinguish the 3 types, in short, is explained below.
|Investment Type||Value Investing||Growth Investing||Income Investing|
|Methodology||Buy undervalued stocks and sell once back in line with valuation||Buy stocks which are growing tremendously and show no signs of a slowdown||Buy stocks with high dividend yield, so that the quarterly or annual dividend can either be used to re-invest or spent on expenses as a substitute for a regular income (e.g. from a job)|
|Main KPIs||P/E Ratio: the lower the better. Depending on the industry we’re looking at P/E ratios below 20, certainly lower than the industry average)|
P/B Ratio: < 1 (means Market Cap < Total Equity)
P/3Y-H Ratio: > 40% discount of current price vs the 3-year-high price
|Revenue: Rising revenues over the last 3-5 years|
Profit: Rising profits over the last 3-5 years
Total Equity: Rising total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising share price over the last 3-5 years
|Revenue: Rising or stable revenues over the last 3-5 years|
Profit: Rising or stable profits over the last 3-5 years
Total Equity: Rising or stable total equity over the last 3-5 years, means assets increasing and/or liabilities decreasing
Price: Rising or stable share price over the last 3-5 years
Dividend Yield: Rising or stable dividend yield, typically between 3% and 10%
|Example||Kier Group PLC|
P/E Ratio: 0.97
P/B Ratio: 0.25
P/3Y-H Ratio: -92% (Current Price: 105.9; 3Y High: 1473 (Mar-17) )
|AB Dynamics PLC|
Revenue: Increase from £13.85m (2014) to £37.05m (2018)
Profit: Increase from £2.65m (2014) to £7.88m (2018)
Total Equity: Increase from £10.33m (2014) to £38.04m (2018)
Price: Increase from 168 (Jan-2014) to 2713 (May-19)
|Royal Dutch Shell PLC|
Revenue: Stable; £421b (2014); £388b (2018)
Profit: Increase from £19b (2014) to £35b (2018)
Total Equity: Increase from £172b (2014) to £202b (2018)
Price: Stable; 2263 (Jan-2014); 2603 (July-19)
Dividend Yield: 5.5%
What is Growth Investing
In essence, the growth investor searches for companies being in exceptional health and having a proven track record of delivering results. With that in mind, the growth investor bets on the company also being able to deliver on expected results in the future, which leads to an appreciation of the companies value and therefore also its share price.
Remember with the Value Investing methodology, we are looking for companies trading below their intrinsic value. Now the growth investor picks companies which are trading above their current book value, but with the outlook of the firm’s future value increasing. This is how we are still getting a good deal when investing today.
The key to growth investing is to still apply a large enough margin of safety in order to not buy companies at their peak-price. This would lead to huge losses when the share price is afterwards falling to be more in line with the company’s current valuation. Applying that margin of safety is a bit more difficult than with the value investing principle, where we can use Book Value and P/E Ratio for our analysis, but we have to use other KPIs and extrapolate them, which we are going to look into below. Let’s look at a theoretical example first.
A theoretical example
Company A is trading on the stock market for 200.00p, with 100m total shares, that results in a market cap of £200m. As the company was growing tremendously over the past 5 years, the stock price is now higher than the current intrinsic value of the company. Investors are likely betting on the continuing growth of the company. The current intrinsic value is estimated at £150m.
Now, because of the company’s proven track record, investors believe the company can continue growing in the future with a similar pace as it was growing in the past. Because of this, the company’s future value will be higher than it is today. If the company’s growth rate per year is estimated at 10%, in 5 years time the company’s value should have increased by 46%. In a market where the share price roughly follows the company’s value, we can also assume the share price has the potential to increase by 46% over the next 5 years.
As growth investors, we need to make sure we’re buying companies at a price point below the predicted future value.
Important KPIs for Growth Investing
In order to find companies suitable for the growth investment approach, we need to look at a few fundamental KPIs, which help us to determine if a company trades above, inline or below its predicted future value. The most important ones are discussed below.
The first KPI we’re looking at is Revenue aka incoming cash flow generated by the company’s sales department.
Important for the growth investor is to see rising revenues over the past 3-5 years. If revenue shows any sign of stagnation or even reduction from one year to the next, this is a clear sign that the growth of a company has stagnated. Either some competitors have eaten into their market share or the overall market segment is on a downturn.
We are searching for companies with steadily rising revenues over the past 3-5 years with a solid annual growth rate. This indicates the company can enlargen their market share and/or trades in a market which sees a general uptrend.
Secondly, we’re looking at a company’s profit aka how much of the revenue is left after deducting all costs and potentially interests and taxes, depending on which profit KPI we’re looking at. I usually use the so-called operating profit, also sometimes referred to as EBIT – Earnings Before Interests and Taxes. As interests and taxes can swing widely from year to year, it is better to exclude those from our analysis.
Similar as with revenue, we’re looking for strong growth in profits over the past 3-5 years, however, a company might decide to re-invest most of their profits during a particular timeframe, hence it is less critical than revenue, that the profits are actually rising. If a company is only making small profits for one year, it makes sense to analyse where the money went. There is no issue if it went back into the company in the form of increased marketing budgets, increased headcount costs or similar.
Finally, we like to see that the efforts of the company are paying off in the long term and the generated profits gradually increasing the company’s total equity.
This can be realised in the form of increasing the company’s assets (like properties, inventory or cash) or decreasing liabilities, e.g. by paying off debt facilities.
If a company generates healthy revenues and healthy profits but doesn’t improve its total equity over time, the company might trade on dangerous, short-termed ground and may collapse soon.
Lastly, we look at the company’s share price.
Naturally, companies which fit our criteria for the first 3 KPIs are trading at a high share price compared to the company’s value. We want to see a rising share price over the past 3-5 years. This gives us confidence that investors are indeed seeing a prosperous future for the company in question.
However, we also want to make sure the company’s share price has not overshot and is now trading far above current valuation and also far above predicted future valuation. A typical scenario which often happens, when investors get ahead of themselves and buying into overhyped companies at skyrocketing prices.
For this strategy, it will be vital to assess a suitable share price to buy into the stock and then sit and wait until the share reaches this price to pull the trigger. Good entry points for growth stocks are usually after a small sell-off. Read more below, how to identify when it is best to buy and when to sell.
When to buy and when to sell when Growth Investing
Given our indicators, as discussed above, we can build a framework for our growth investing methodology. Note, that we don’t necessarily have such a stringent approach here as we have set-up with the Value Investing methodology.
We buy companies with the following set-up:
- Revenues rising over the past 3-5 years
- Profits rising over the past 3-5 years
- Total Equity rising over the past 3-5 years
- Share Price rising over the past 3-5 years
As growth investing is only in part of fundamental nature, I’d like to bring a few technical aspects into this methodology.
In order to calculate my target price for a particular company, I estimate the growth rate for the next 12 months to be the average growth rate of the last 3 years. This is my annual extrapolation. Additionally, I look into extrapolating on a quarterly basis. I hereby estimate the growth rate for the next 2 quarters to be the average growth rate of the respective same quarter in the past 3 years.
Finally, I look into broker targets and average those with my annual and quarterly extrapolation values. What remains is my 6-12 month target price for a stock.
In order to avoid buying a company at the top of an uptrend and then having to face losses on the following pullback, I always wait first for the pullback to happen and then invest. Alternatively, I buy once the price breaks out of a range of consolidation.
Once invested, I add to my position whenever we see these patterns recurring, meaning pullbacks and breakouts give us nice opportunities to add to our investment as long as we’re still below the estimated target price. It is also important to re-calculate the target price from time to time, as well as check updated broker forecasts. Holding the stock over multiple quarters may have an effect on the extrapolated target price as well.
Once the share price approaches the target price, we stop adding to our position and prepare to sell and take our profits once the target price has been reached. Because growth stocks can sometimes catch momentum and suddenly skyrocket, I usually sell half of my position at my estimated target price and sell the other half at a later point, either when I see the price consolidating or the trend reversing.
Examples of Growth Investing
One of the value investments in my current portfolio is AB Dynamics.
In January 2019 we were looking at the following set-up:
- Revenue: Increase from £20.47m (2016) to £37.05m (2018); 81% increase over 3 years
- Profit: Increase from £4.38m (2016) to £7.88m (2018); 80% increase over 3 years
- Total Equity: Increase from £17.52m (2016) to £38.04m (2018); 117% increase over 3 years
- Price: Increase from 343 (Jan-2016) to 1480 (Jan-19) ; 331% increase over 3 years
Our annual extrapolation formula delivers us an estimated annual growth rate of 62%. This averaged out with our quarterly extrapolation, as well with broker targets sets the current target price to 2300 – a nice 55% profit potential.
There would’ve been a chance to add to my position at the end of March after the pullback starting from mid-march, although I missed that chance. Afterwards, the price skyrocketed and shot over my target price already. Hence, I’m currently prepared to sell or ride another breakout after the consolidation we’re currently seeing in July 2019.
How to find opportunities for Growth Investing
Now that you know what growth investments are, all you need to know now is, how to find growth investment opportunities in the market.
Here’s how I’m scanning the market for opportunities and assessing them accordingly to the discussed methodology.
1. Use a stock screener
While you can use a stock screener to find growth opportunities in the market, it is a bit more difficult here than it is for value investments. I usually scan the market by industry or simply look up stocks I read about in the news or magazines.
The KPIs I’m looking at in the screener are:
- Share Price above 10p (to avoid penny stocks)
- P/E Ratio over 0 (Company has to make profits)
- I order the list descending by Yearly Performance, to see the stocks with the biggest increase in their share price in the last year first
For that purpose, I use the screener from trading view: https://uk.tradingview.com/screener/
There, I built a simple screener showing fundamental data as shown in the screenshot below: Ticker Name, Last Price, Market Cap, P/B Ratio, Yearly Performance, P/E Ratio, Annual Revenue, Number of Employees, Dividend Per Share, Total Shares and Industry.
It is free to use, but you can go Pro, if you want to export the data, have more timeframes available and get the screener to auto-refresh. With the Pro version there are a lot of other benefits as well, see a full breakdown here: uk.tradingview.com/gopro/
2. Get more information for the stock
Once I have discovered a suitable stock in a strong industry, with healthy revenues and strong growth of the share price in the last year, the next step is to analyse more data. Herefore, I go to Hargreaves Lansdown (HL): hl.co.uk/shares
HL provides a lot of information about a particular stock, amongst others Charts & Performance, News, Broker Forecasts, Financials and Dividends.
For the Growth Investing methodology, I’m most interested in the companies revenues and profits over time, total equity as well as any broker forecasts. We find this information on the Financials tab, where I can view annual and interim reports as well as the full balance sheet over the past 5 years.
3. Pull all information together and make an informed investment decision
Finally, we need to pull all the gathered information together to make our informed investment decision.
For this purpose, I developed an Excel tool, which is illustrated in the screenshot below.
I enter the stock I want to analyse into the tool and it automatically pulls the historical performance data as well as current Bid and Ask Price. It also calculates the target growth rate for the current year based on our extrapolation formula. We fill in the collected data, like the broker targets, P/B ratio, Dividend Yield and P/E ratio to complete the data set.
The tool will then calculate the potential for profit if invested at the current price and sold at the target price. As a rule of thumb, I’m currently looking for profit potentials of at least 40%, in order to have a large enough margin of safety, in case the investment doesn’t play out as anticipated.
If you are interested in this tool, please contact me on [email protected] or drop me a message on social (see buttons below).
This is how to utilise Growth Investing as an Investment Strategy for your Portfolio. I hope you enjoyed reading this article and let me in the comments below if you are utilising this method in your investment portfolio and how this works out for you.
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