As growth becomes scarce in the low-interest environment, investors have been piling into a select group of shares, pushing them up relative to the rest of the market. Growth shares are shares of companies growing revenues and earnings faster than the rest of the market as investors realize growth companies as a group have out outperformed value shares over the last decade.
Stages of Growth
The stages below is a broad outline of the main stages companies goes through to be a mega capitalization stock. 99% of the time, most companies stop before this. Sometimes the journey is just as important as the destination.
- Seed
- Venture Capital Capital
- Small-Cap
- Mid Cap
- Large Cap
For investors in the listed shares, small and mid-cap companies are usually the market segment that experiences the fastest and consistent rate of growth as they have multiple avenues where they can accelerate their growth.
- They can increase their revenues either by taking market share from existing established market players.
- Easy to avoid the drag from the law of large numbers. It is much easier for a company to increase $100 million in revenue from $1 billion the year before compared to a $10 billion revenue company to have the same rate of increase.
- The total addressable market for their product is still untapped for their product or service, and the runway is still very long.
Most companies experience various stages of development, starting from product or service development and market acceptance. It then shifts to a growth phase where it starts to take market share, where it is consistently achieving double digits growth for years and eventually becomes a large-cap stock and a staple of the index funds.
A prime example of a growth share is the mega-cap technology companies like FANG (Facebook, Apple, Netflix and Google), synonymous with the current cycle’s growth investing style. Because of these companies, Nasdaq (and to an extent, the S&P 500) has outperformed other major equity markets worldwide.
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These tech companies got to today from creating value for customers and inventing new markets where they can dominate completely—Google in search, Facebook in social media and Netflix in streaming.
A positive aspect of growth is that it can benefit from the increasing economies of scale or network effect to use its existing market position to its advantage, like the case where the Microsoft Windows operating program dominated the desktop operating environment. It built on this platform via Office, Outlook and gaming.
The downside is eventually, the law of large numbers will catch up with these companies face fewer investment opportunities left where the size of the market can make a material impact, such as Apple, when its growth slowed as the iPhone and iPad business matured. It found it was harder to grow and moved to smaller opportunities in wearables (iWatch). To fuel its growth, Apple has to expand out from its traditional comfort zones in TV and cars.
Why do people buy growth shares?
- Investors buy growth shares hoping revenues will translate into earnings.
- Expect the trading multiple of companies will continue to expand as other investors pile into the same stock or buying into the growth story.
- There is a high level of correlation between growth and momentum shares. A momentum strategy is when the main driver of returns from owning the share is to continue to bet that the company is growing and attractive enough that a larger group of investors will buy the shares down the track (similar to the greater fool theory).
- Sometimes, investors can get carried away, jump on the hype wagon, and overlook the investment’s underlying quality. A prime example of this was the Ant IPO.
- There are always a group of investors looking for growth, and as the world shifts into a low growth gear, the investment universe gets smaller and smaller there are no alternatives (TINA).
- Growth has outperformed value so that past outperformance will continue (chicken and egg argument).
Growth Companies on the ASX
The ASX growth share list is a shortlist of companies from the ASX 200 index increasing either revenues or earnings at multiple of the market average.
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The most common group of growth shares listed on the ASX today belongs to the buy now pay later shares. Companies like Afterpay and Z1P are the first port of call and pure examples for looking for a secular growth story on the ASX.
Other sectors that commonly experience fast growth include mining shares during mining booms.
Growth ETFs
Growth can be segmented into a smart beta factor. Like dividend ETFs there are Exchange Traded Funds on the ASX explicitly designed to track a portfolio of companies that reflects the growth factors. Another way of gaining exposure to growth shares is to own a fund that invests just in companies with characteristics of growth shares.
Risks of owning growth shares
One of the most significant risks is the faster they rise, the greater the fall. The chart of growth shares follows the classic case staircase pattern when the share price rises and the elevator down when the share price is falling. Nothing is scarier than owning a growth company going ex-growth. Once the growth story is over and everyone is heading to the same exit, there can be a large move down in share prices where the sell-off can be very savage.
Growth Expectations
For these types of shares, the market expectation of future growth is just as important as the actual outcome. For example, the company reports a 15% increase in earnings. Still, the market is expecting 20%. The market is expecting higher growth. It extrapolates using the last data point, so a minor miss extrapolated into the future could result in a considerable variation in share prices. Hence the shares will still get sold off to reprice the lower expectation in the future.