Growth Investing

Growth investing is an investment style that focuses on companies expected to increase their revenue and earnings faster than the average business or the wider economy. Growth investors are willing to pay high prices relative to current profits, because they expect the company's future earnings to justify the price. They look less at dividends, which fast-growing companies often do not pay, and more at the long-run increase in the share price.

Growth investing is usually set against value investing, which looks for shares priced cheaply relative to their assets or earnings. The companies it targets are known as growth stocks, and funds that follow the style are classed as growth-style funds. Index providers such as S&P Dow Jones Indices, FTSE Russell and MSCI publish separate growth and value indices so that managers in each style can be compared with a fair benchmark.

Picture two orchards for sale. One is mature: its trees produce a steady crop and the price reflects that. The other has young trees that produce little today but are expected to bear far more fruit in ten years. A buyer of the young orchard pays a lot for today's small harvest, betting on tomorrow's big one.

A growth investor is the buyer of the young orchard. The price looks expensive against today's profits, but the investor expects profits to multiply. If the trees grow as hoped, the bet pays off handsomely. If they are struck by disease or another orchard steals the market, the buyer has paid a high price for very little.

Thomas Rowe Price Jr., who founded the Baltimore investment firm T. Rowe Price in 1937, is often called the father of growth investing; he argued that investors should buy companies in the growth phase of their life cycle and hold them for years. Philip Fisher set out the approach most fully in his 1958 book Common Stocks and Uncommon Profits, which listed fifteen points to look for in a company, including the quality of management, spending on research and development and the ability to keep growing sales for years. Fisher also described "scuttlebutt" research: talking to customers, suppliers and competitors to judge a business. Later, the fund manager Peter Lynch popularised the PEG ratio as a way of judging whether a growth company's price was reasonable.

• Revenue and earnings growth. Rapid, sustained growth in sales and earnings per share, often well above the market average.
• Market opportunity. A large or expanding market, frequently in technology, health care or new consumer habits.
• Competitive position. Products, networks or brands that are hard for rivals to copy.
• Reinvestment. Profits ploughed back into expansion rather than paid out to shareholders.
• Valuation relative to growth. A high price-to-earnings ratio is accepted if growth is fast enough.

The PEG ratio relates the price-to-earnings ratio to the expected growth rate:

• $P/E$ is the share price divided by earnings per share.
• $g$ is the expected annual earnings growth rate, written as a whole number (20 for 20%).

A company trading at 30 times earnings with expected growth of 20% a year has a PEG of $30 \div 20 = 1.5$. One at 15 times earnings growing 15% a year has a PEG of 1.0. By Lynch's rule of thumb, a PEG near 1 suggests the price is in line with growth, though the measure is only as good as the growth forecast.

Growth stocks tend to do best when interest rates are low, because much of their value lies in profits expected far in the future and those profits are discounted less heavily. The long bull market of the 2010s, during the zero interest-rate era, favoured large technology companies, and growth indices outperformed value indices for most of that decade. The reverse happened in 2022, when rising rates hit growth shares hardest. Growth investors may hold large-cap stocks or concentrate on small-cap stocks and recent initial public offerings, and they often have a long time horizon.

The main risk is paying too much for growth that never arrives. Because prices already assume strong future results, a small disappointment in quarterly earnings can cause a sharp fall. The dot-com bubble is the classic example: the Nasdaq Composite index peaked on 10 March 2000 and lost close to 78% of its value by October 2002, wiping out many companies that had been valued on growth alone. Growth portfolios also tend to show higher volatility and higher beta than the market. Academic research by Eugene Fama and Kenneth French in the early 1990s found that, over long US history, cheap "value" shares had earned higher average returns than expensive "growth" shares, although that gap has been much smaller or reversed in many periods since 2007. Many investors therefore hold both styles as part of their diversification.

• Kenneth R. French Data Library (Tuck School of Business, Dartmouth)