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Why Investors Prefer Growth Investing Over Value Investing

by Q.ai Team

What Is Growth Investing?

Growth investing is an attractive stock-buying investment strategy that focuses on long- or short-term capital appreciation. Growth investors invest in growth stocks, which may be the shares of young companies, companies that have only recently started publicly trading, or scaling startups with earnings that investors expect to increase at an above-average rate when compared to the industry sector or overall market.

That said, these are companies that don’t usually distribute their earnings in dividends. Growth investors may accept this due to the rapidly increasing company value, while other investors may decide that a risky bet with no return in the interim isn’t worth it.

What Are Some Popular Growth Investment Types?

There are a few types of investments that have historically shown great growth. While these usually come with a higher level of risk, there’s also huge potential.

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  • Small-Cap Stocks — These are smaller companies, compared to micro, mid and large-cap firms. Because they’re still in the early stages of growth, their stock prices have substantial potential for appreciation.
  • Technology Stocks — Companies at the helm of innovative technological advances have rapidly risen in the past.
  • Healthcare Stocks — Companies within the healthcare sector that develop revolutionary products and services have high potential to exponentially increase in price in a relatively short time period.

How Is Growth Investing Different from Value Investing?

Growth investing is not the only investment strategy that focuses on capital appreciation. Value investing is another strategy with a similar aim but a totally different approach. All stocks are considered either growth, value or blended (growth and value) investments. While growth investors tend to disregard indicators that suggest a stock may be overvalued, value investors look into stocks that trade below their inherent value.

Growth investors don’t pay as much mind to the present price of the stock, so long as they see potential in the company that’d ultimately increase that price when they want to sell their stock. These stocks may, therefore, be more expensive and carry a lot more risk.

Value investors, however, are known as the bargain hunters of investors because they place emphasis on current valuations that are lower than where they theoretically should be and are, thus, likely to change in the foreseeable future. Basically, value investors look for the diamonds in the rough, hoping that the market will eventually recognize the company’s value and the stock will increase in price accordingly.

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While both investing strategies work well for different types of investors, growth investing is a forward-thinking approach that is attractive to those who are willing to pay more and face higher risk. For example, younger investors with longer time horizons and higher tolerances for risk may make better growth investors than those who have less wiggle room for volatility.

How Can You Mitigate Risk in Growth Investing?

Buying stock in emerging companies can provide impressive returns if they ultimately expand and succeed. That’s because the growth in an emerging company would, ideally, translate into high stock prices down the line. In other words, there’s a lot of untapped potential in these stocks. That’s why many growth investors are willing to pay more for them; the potentially life-changing returns seem worth it.

But with untapped potential for extraordinary returns comes high risk. Therefore, growth investors tend to consider five key factors when evaluating stocks in which to invest:

  1. Historical Earnings Growth — The company should show a strong track record of earnings growth over the last several years. The percentage will depend on several factors including the company’s size but, if it’s doing relatively well, growth investors may presume that it’s likely to continue doing well.
  2. Future Earnings Growth — The company should also show a strong forward earnings growth rate. The company may offer a public earnings announcement for a specific period, such as a quarter or the year, with above-average growth estimates issued by equity analysts.
  3. Pre-Tax Profit Margins — The company should exceed its previous average of pre-tax profit margins (and those of the industry) for the last few years. This is because, while the company may have impressive sales growth, it could still have poor earnings gains.
  4. Returns on Equity — The company should have an attractive return on equity (ROE), which shows how much profit it generates with the money that shareholders have invested in it. Basically, the ROE suggests how efficiently a company can make a profit. The ROE is quantified as a percentage that’s calculated by dividing the company’s net income by the shareholder equity. The result should be higher than the company’s previous returns on equity.
  5. Share Price Performance — The share price should be rapidly increasing over the years in order to be considered a growth stock. A higher growth rate can be feasible for many emerging companies in expanding industries and markets.

Beyond the aforementioned factors, growth investors will look into the market opportunities, any competitive advantages the company may have, the companies’ business models, the corporate cultures, the leadership styles and other indicators that these companies have serious shots at success. After all, the attraction and retention of talent, as well as the commitment and dedication of the leadership team can drastically affect a company’s potential to epically explode or totally flunk.

Of course, if growth investing doesn’t seem right for you, there are alternative strategies out there.

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