When you buy a stock, you become a part-owner of the underlying company's assets, and you're purchasing a claim on the earnings generated far into the future. A growth investing strategy focuses on companies that have exceptionally bright outlooks for these sales and profit gains, since drastic improvements in these metrics can produce life-changing long-term returns for shareholders who sit tight.
Here we'll take a comprehensive look at how a growth-centered investment approach can beat the broader market, and we'll also dive into the top growth stocks for the year ahead.
Image source: Getty Images.
What is a growth stock?
All publicly traded companies aim to boost their sales and profits each year to appease shareholders who demand returns on their investment, but particular equities known as growth stocks typically enjoy a faster expansion rate than their peers. That rapid pace stands out in comparison to so-called value stocks, equities out of favor on Wall Street because of disappointing operating results. The hallmark of a value stock is flat or declining sales, or some other combination of sour industry trends that persuade investors to sell shares, pushing the price down to a discounted, or relatively cheap, valuation. By valuation, investors refer to a company's price as a multiple of key operating metrics such as earnings or sales.
Because market sentiment can change quickly on Wall Street, in both positive and negative directions, value stocks are the choice of many investors who hope to profit from temporarily pessimistic views of a company's business. When conditions improve, the thinking goes, these stocks will rebound to be valued more equally with their peers.
Growth stocks, on the other hand, have a history of market-thumping growth and a bright outlook for the future, which persuades investors to push their stocks up, so that they trade at a premium to their rivals and the broader market.
On traditional valuation metrics such as price-to-earnings , growth stocks can command prices many times higher than average. It's not uncommon to see a growth stock valued at 50 or 60 times the past year's earnings, while the broader market is priced at around 20 times earnings and a value stock is priced at below 10 times earnings. These valuation ranges simply reflect the collective judgement of investors, who are far more optimistic about the profit potential for a quickly growing business than they are for companies that are reporting flat or declining results. Meanwhile, growth stocks, because they prioritize reinvesting profits into the business, typically don't pay out dividends , or direct cash returns to shareholders.
That pricing gap makes growth stocks riskier than their more conservatively valued peers, because even a small operating stumble can send share prices careening. A stock valued at 60 times the past year's earnings can easily fall to a P/E of 30, for example, while a discounted stock has less distance to decline. Meanwhile, growth stocks are by definition more speculative because investors are betting on future gains that may or may not materialize, a feature that amplifies price swings as shareholders react aggressively to small shifts in long-term outlooks.
The upside is that these stocks can produce massive long-term returns for investors if the businesses continue succeeding as they have in the past, and if Wall Street remains just as optimistic about their future operating results.
Key trends to look for in growth stocks
Just because a company is growing quickly, that doesn't mean the stock is a growth stock and a good investment opportunity.
Unusually strong sales gains are a basic requirement when looking for attractive growth stocks, but they don't tell the whole story. Sure, surging revenue reveals a few important things about the business, including that demand is growing for its products or services, the company is absorbing market share, and the business is growing its sales base. That success could help it grow its market capitalization , or the total value assigned to a business found by multiplying its current stock price by its number of shares outstanding. Growth stocks usually have smaller market capitalizations during their initial stages of expansion and then grow quickly after achieving scale.
Investors often lend growth-focused companies a temporary pass when it comes to profitability, since management teams should prioritize market share gains rather than short-term earnings results -- especially if the market opportunity is sufficiently large. It would have been financially irresponsible, for example, if Starbucks decided not to reinvest most of its profits toward building out its store base to blanket the United States with its cafes in the late 1990s. While the spending reduced earnings during those years, more importantly, it laid the groundwork for massive sales and profit gains to come. Growth investors interalize delayed gratification.
That said, it's critical for a growth stock to show that its business can generate profits, even if a steady earnings stream is still years down the line. A clue is its pricing power. Pricing power is a company's ability to increase its prices without sacrificing its growth pace. A company with pricing power demonstrates that it supplies something customers will buy no matter its price.
The metrics investors follow to judge this pricing power include gross profit margin and operating margin , which describe the percentage of sales a company turns into profits. Cash flow is important, too, since no company can operate for long by spending more cash than it generates with the business.
Gross profit margin is helpful for evaluating a company's pricing power. If it can consistently charge higher prices than its peers, as Apple does, then there are probably important competitive advantages at work, such as branding, scale, or unmatched product development.
Operating margin includes expenses, so it illustrates whether a company is profitable and is doing a good job of managing its costs. Growth stocks often fall short in this area because they're reinvesting cash into the business at a disproportionate rate. This scenario can't continue for long, though, so management should always have a plan for reaching sustainable operating profitability.
If cash flow is negative, a growth company will make up the difference by issuing more debt. This way of keeping afloat is unsustainable, so it's important to see this metric continually improving.
Keep in mind that many companies fail to turn a period of sharp sales growth into an enduring business, for any number of reasons, including unfavorable industry shifts such as that the one that decimated the shares of wearable-electronics upstart Fitbit (NYSE: FIT), which lost more than 80% of its value after peaking in 2015. Growth flops also occur because of management failures such as the series of product launch disappointments that contributed to more than a 90% decline in GoPro (NASDAQ: GPRO) stock since late 2014. In both cases, these companies weren't able to take runaway initial success in one arena and scale it up to a broader, defensible market niche.
Finally, it's important that a company have a long growth runway ahead, or, put simply, a lot of future opportunity. Its outlook should be posited to benefit from shifting consumer trends -- think disruptive changes such as e-commerce or on-demand home entertainment. These moves have the potential to help their industries grow at faster than average rates for many decades. In contrast, a utility company, which services a highly regulated and roughly stable customer base, won't grow its sales or profits much faster than the overall economy.
Finding growth stock candidates
Now that we know what to look for -- and what to avoid -- when hunting for a top growth stock, let's dive into a few candidates that appear poised for exactly the right type of robust operating gains in 2019 and beyond.
The industries they span -- internet entertainment, sports apparel, premium alcoholic beverages, e-commerce, and robotic cleaning devices -- have each expanded at unusually fast rates in recent years and appear set for even bigger gains over the long term.
Lululemon for its profit margins
Athletic-apparel retailing is a risky business, which is a lesson lululemon athletica (NASDAQ: LULU) learned the hard way in 2013, when quality-control issues hurt the brand. The business has put that struggle in the past, going through a period marked by improved product innovation, a management shakeup, and a sourcing restructuring. Annual sales passed $2.6 billion in fiscal 2017 to mark a 13% increase over the prior year and a 67% jump since 2013.
Growth looked even better in 2018, trouncing earnings targets in each of the first three quarterly reports of the year. It appears that its branding, marketing, and product innovation strategies are working.
Better yet, the yoga-inspired apparel retailer has seen profitability march back up toward the record it set before brand issues forced the business into recovery mode. Gross profit for the first three quarters of 2018 crossed $1.1 billion, or 54% of sales, compared with $876 million, or 51% of sales, in the year-ago period. CEO Calvin McDonald and his executive team expect to pass $4 billion in annual sales by 2020, and with 2018's results on pace to cross $3.2 billion, that target no longer seems like a stretch.
Lululemon's longer-term outlook appears even brighter. The company's geographic focus has been in its core North American market, but there's a huge global opportunity. Competitor Nike has bet heavily on building up its China presence. Lululemon also hopes to expand beyond its traditional female demographic to market to more men and cater to sports outside yoga and light fitness pursuits.
Each of these opportunities could add hundreds of millions of dollars to the company's annual sales, which is why executives are doing everything in their power to develop the retailer's strengths here. Those new growth avenues will bring new challenges and will pit the retailer against firmly entrenched competition that won't be eager to cede its market share. However, if the company keeps resonating with consumers as it has in recent years, it has a good shot at maturing into a powerful global retailer, booking far more than the $4 billion of annual revenue it's targeting for 2020.
Wayfair for its growth in online furniture shopping
If doubts lingered about whether consumers are comfortable making online purchases of home furnishings, including bulky items such as sofas, rugs, and mattresses, Wayfair (NYSE: W) puts those concerns to rest. The e-commerce retailer posted a 43% sales spike in fiscal 2017, as its customer base passed 11 million users. Other key metrics suggest that the company is building valuable shopper loyalty, too, as repeat orders accounted for 62% of all sales volume, up from 58% in the prior year.
Wayfair has expanded its market share despite aggressive price-based competition from rivals such as Overstock , and that success further supports the conclusion that it controls a highly defensible position in an attractive market. There's no sign the industry will slow down over the long term, either. Wayfair managed a 58% sales spike during the key holiday shopping period between Thanksgiving Day and Cyber Monday in late 2018, representing accelerating gains compared with the prior year's 53% increase. Recent growth was driven by new market niches such as vanities, which means its delivery platform could expand beyond traditional home-furnishings segments.
The retailer has generated losses in all of its past five fiscal years, including $244 million of red ink in 2017, and that's a big knock against the stock today. Executives are pouring resources into several growth initiatives, including improving the digital shopping experience, building out a proprietary delivery network, and expanding into international territories. With those investments taking up far more cash than the company generates, it's unclear how soon Wayfair might reach the financial targets management laid out, which call for adjusted profit margins between 8% and 10% of sales -- compared with roughly 2% losses in each of the past two years. However, its dominant grip on this quickly growing market should make it easier to generate significant profits once Wayfair's spending needs start settling down.
Netflix for its recurring revenue and international growth opportunity
For decades, the broadcast media world delivered large and growing profits to companies in niches such as cable TV and pay-TV networks. These businesses generated earnings from their shows or their delivery platforms. Entertainment conglomerates such as Disney , meanwhile, were able to profit from both their TV content and from their broadcasting platforms. That entire industry is rapidly moving online, and Netflix (NASDAQ: NFLX) is positioned to reap significant rewards from this shift over time.
The subscription TV service closed out an epic growth year in 2017, with subscriber gains passing 8 million, compared with management's expectations of adding 6 million members. It was the company's fourth straight year of accelerating annual growth, but a few aspects of these gains imply that there's much more room for expansion ahead.
For one thing, Netflix is growing quickly despite higher monthly membership prices, representing the company's pricing power. Second, the streaming giant has expanded its user base in the U.S. but has grown even more dramatically in international geographies that represent a much larger addressable market. Finally, Netflix's content base is shifting toward owned and exclusive shows and movies, which are both more profitable for the business and more likely to attract a growing and loyal customer base.
Those positive trends drove robust sales and profitability growth for Netflix in 2018. Netflix has also attracted new streaming entrants, with Disney set to launch its own competing service toward the end of 2019. The prospect of rising competition, in addition to the company's surging debt , means Wall Street has been more cautious about Netflix stock. However, the fact that Disney is moving into the subscription TV industry confirms that it's probably where most of the growth will occur in the decades to come. And Netflix, with its 130 million global subscribers, has a formidable lead in what should become a massive market over time.
Similarly, while its worsening cash flow is a concern, CEO Reed Hastings and his team aren't expecting to operate in that negative state for much longer. And their aggressive spending has major benefits, including faster membership growth. The content budget could approach $10 billion in 2019, a figure even a massive entertainment business such as Disney would require years to rival.
Constellation Brands for its premium franchises
Constellation Brands (NYSE: STZ) has a habit of making bold acquisition gambles that work out well for shareholders. The company spent billions to acquire the rights to market premium imported beers Corona and Modelo in the U.S. in 2012, and that purchase has helped earnings expand at a 20% or better clip in each of the last five years. That beer business has been expanding sales at a double-digit rate, too, while the larger beer giants struggle with minor volume declines.
The company just made another head-turning investment, this time in the burgeoning field of consumer cannabis products. Its $4 billion equity stake in Canopy Growth ensures Constellation Brands a leadership position in what could become a large global market for cannabis-infused beverages. Today, that addressable market is largely in Canada, where weed recently became legal for recreational consumption. Sales are likely to grow in the U.S. over time, too, though, although marijuana remains illegal at the federal level.
However, investors don't have to hope for a big payoff in this unproven industry to see solid returns from this stock. Constellation Brands' beer business is likely to generate strong earnings and cash flow for years to come, after all, thanks to its premium industry position and the aggressive investments that management has made in its network of breweries in Mexico and the United States.
With industry-leading sales growth, improving profit margins, and a proven portfolio of popular adult beverages, Constellation Brands has a bright future. And if the Canadian marijuana legalization story plays out in a positive way, that might just be a bonus for growth investors starting as early as 2019.
iRobot for its leadership position
Wall Street keeps predicting that an influx of competition will crush iRobot 's (NASDAQ: IRBT) dominant market position, but the robotic cleaning-device company continues to prove skeptics wrong. Sales jumped 34% in 2017, as the company tightened its grip on the premium vacuum-cleaner niche. Pricing held up well, too, thanks to innovative releases that brought features such as room mapping and cloud connectivity to its lineup of robotic vacuums. Gross profit margin ticked up to 49% of sales in 2017 from 48.3% in 2016 and 46.8% in 2015.
Image source: Getty Images.
Bottom-line profitability is on the decline, though, as the company spends aggressively on marketing, as well as on research and development. That's usually a warning sign for a business, but in iRobot's case it reflects a calculated management gamble. CEO Colin Angle told investors that the industry is at an inflection point, where the companies that can establish firm footing will go on to capture most of the growth over the next decade . iRobot sees a lot of possible gains ahead, too, including by doubling its installed base in U.S. households over just the next few quarters.
To make progress toward that short-term goal, and its longer-term target of surpassing 100 million homes in the core U.S. market, iRobot needs to keep its Roomba franchise well ahead of the competition in terms of functionality, branding, and pricing. That was the goal of the launch of a refreshed lineup of devices in late 2018 that can allow for weeks of automated vacuuming without any input from the owner. iRobot also must prove its ability to launch complementary products, such as its new mopping lineup, so that it establishes itself as more of a robotic cleaning specialist that caters to all aspects of smart-home maintenance rather than just a niche player with a popular vacuuming brand.
Its newest two devices will account for about 25% of the over $1 billion of sales iRobot expects to earn in 2018, with a significant portion of that total over the key holiday shopping season. These two facts help highlight the risks associated with this consumer-focused, tech-heavy business. However, the assets it brings to this challenge, including formidable intellectual property and strong branding, suggest iRobot has a good shot at holding its dominant industry position as the robotic-cleaning niche moves into the mainstream.
Growth investing in 2019 and beyond
Any one of the stocks we've profiled could suffer a flameout in 2019 or in the coming years. And because the shares are all valued at a premium today, the concurrent price decline would be sharper than what might occur with a more slowly growing stock. That amplified risk of loss is the key drawback that growth investors must accept. However, by focusing on quality businesses with established track records, you can minimize that risk while giving yourself a good shot at owning a company that goes on to generate many multiples of the annual earnings it achieved when you first purchased it.
Don't miss out on growth stocks, which can help pull your portfolio up, and up, and up.
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Demitrios Kalogeropoulos owns shares of Apple and Netflix. The Motley Fool owns shares of and recommends Apple, iRobot, Netflix, and Wayfair. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Constellation Brands and Lululemon Athletica. The Motley Fool has a disclosure policy .