Growth stocks are having a good year. While the UK stock market has bobbed along sideways in 2023, the Nasdaq Composite has rallied 36%.

By Shares’ calculations, about 70% of the top 50 performers on the S&P 500 can be comfortably called growth companies, led by Nvidia’s (NVDA:NASDAQ) near-240% share price jump.

This potential for outsized gains is why investors buy high-growth stocks, or funds exposed to them.

WHAT ARE HIGH-GROWTH STOCKS?

In simple terms, growth stocks are companies that are expected to consistently generate above average growth in future revenue and earnings. Investors who buy growth stocks often believe these companies will deliver strong financial results far into the future as it finds an ever-expanding market for its products and services.

The bottom line is that growth investors seek out companies that have a long runway for fast sales and earnings expansion, and those able to do so attract investors like moths to a flame, resulting in higher valuations.

There are no standard growth stock criteria, each investor or fund manager may develop their own bespoke list of metrics, but let’s look at some of the more popular ones.

● Strong sales growth: The best growth-oriented companies significantly increase their revenues over time since the only reliable way to grow profits for years on end is to grow revenues too.

● Rising profit margins: The best growth stocks are those of companies with profit margins that are increasing over time. Profit margins that are negative but become positive while an investor holds the stock can result in significant share price increases, generating very high returns for the investor’s portfolio. Other rapidly growing companies are already profitable and but are still able to profit margins through pricing power and economies of scale, for example.

● Projected growth of earnings: Analysts projecting that a company’s earnings are likely to grow is a positive sign, and though analyst projections are far from fail safe, they are useful for gauging market expectations.

● High returns on equity: Return on equity is a useful way of measuring how much extra value the company is creating for shareholders per pound invested. It is calculated by expressing net income as a percentage of shareholders’ equity.

LITTLE-KNOWN ‘RULE OF 40’

The ‘Rule of 40’ is increasingly being adopted by high growth company executives as an important metric to help measure the trade-offs of balancing growth and profitability. Many retail investors may be unfamiliar with the term, yet it is simple to understand and easy to apply and can be a useful tool for deciding if a particular growth stock is right for your portfolio.

It is principle that a company’s combined sales growth rate and operating profit margin should add up to at least 40, and ideally better. Investors using this metric therefore consider a company with a score of 40 or more to be a good investment opportunity and a figure below 40 to be of less interest.

The metric neatly captures the fundamental trade-off between investing for future growth – such as developing new products and acquiring new customers – and short-term profitability.

Venture capitalists originally used the premise to assess software start-ups, particularly those that were growing fast but running up huge losses. It is today regularly used to assess any fast-growing digital economy company, and there’s no obvious reason why it cannot be applied more widely.

It’s fair to say that growth stocks tend to perform best during bull markets for two main reasons:

● One - when the economy is growing and everyone is feeling confident, consumers, businesses, and governments are more likely to spend on products and services. So, a strong economic environment tends to drive sales for good growth stocks.

● Two - during bull markets, growth investors often quickly buy up shares of companies that show they’re riding a strong wave of growth. This bullish investor behaviour can drive highly rated growth stock share prices even higher.

That said, growth stocks can also be surprisingly good investments during times of slowing economic growth or even bear markets. They often have high recurring revenue, lending a level of predictability and visibility many other companies struggle for.

They can also offer customers way of improving efficiency and saving money, a strong selling point. Those that are well-funded, often with net cash on balance sheets, are also able to take market share from less well-funded rivals that hit the skids when easy capital dries up.

WHAT ARE THE RISKS?

Investing in growth stocks can be risky because investors have often already bid the stocks up to high valuation multiples based on strong growth. If growth ever disappoints, the stock price is likely to fall, sometimes dramatically.

Growth stocks also tend to be more volatile than mature, modestly rated ones, although this varies hugely depending on the company.

Many also don’t pay dividends, they perceive reinvesting surplus capital back into the business for better future returns rather than handing it back to shareholders. This pitch is usually welcomed by investors who want exposure to above average performance, but it does mean that your returns will be reliant on capital growth, which doesn’t suit all investors.

Higher exposure to growth will likely suit younger investors with a longer investment horizon ahead of them. But for many, growth stocks form part of a diversified portfolio rather than being all in, it’s a way of diminishing portfolio risk.

When deciding whether to invest in growth stocks, there are several things to consider. The first two factors are your risk tolerance and whether you can handle volatility. Any perceived changes to a growth company’s outlook can affect its share price.

They also tend to require a longer-term mindset since often you are buying in to future profits years in advance, rather than those earned today.

OTHER WAYS TO INVEST IN GROWTH STOCKS

Some investors can get stressed out when they see a stock rising and falling rapidly within a short time. But rather than avoiding growth stocks entirely, you could consider growth funds, ETFs and investment trusts as a way to add a little growth spice to your portfolio through an already diversified portfolio of investments.

The simplest option, and among the lowest cost, would be a vanilla Nasdaq 100 ETF. The Xtrackers Nasdaq 100 UCITS ETF (XNAQ) is a full replication fund of the Nasdaq 100 index, the 100 largest companies on the Nasdaq market. This includes massive growth companies like Microsoft (MSFT:NASDAQ), Tesla (TSLA:NASDAQ) and Nvidia, for an annual charge of 0.2%.

An alternative growth option might be a vehicle which tracks the mid-sized companies among the FTSE 250. This index is home to many of the UK’s best growth companies, while their relatively modest market caps imply potential for substantial value creation over the years. The Vanguard FTSE 250 UCITS ETF (MVID) ETF has an ongoing charge of just 0.1% a year.

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