Growth stocks are the financial market's land of opportunity -- stocks that show the potential for abundant share price growth over the long haul but sell for relatively cheap right now.
There's data to back the sentiment up. The Morningstar U.S. Growth Index has returned 28.6% so far in 2019 and has a stellar 19.27% average return over the past three years.
For definition purposes, growth stocks cover companies that are generating earnings at an accelerated rate and often come from the technology or biotechnology sectors. There, growth opportunities are a fact of life for a company that produces a game-changing technology product or is delivering on a commercially successful drug pipeline.
Growth stock investors are willing to pay a premium to buy shares of these companies, paying higher prices relative to actual earnings in the hope that the company will take off and produce blockbuster returns once its products or services hit the marketplace.
Think of it this way. At one time, Apple AAPL , Amazon (AMZN) - Get Report , Gilead Sciences (GILD) - Get Report and Cisco Systems (CSCO) - Get Report was all growth stocks at one time, and all have gone on to produce armies of millionaire shareholders.
Certainly, most growth stocks don't boast that kind of performance, but the notion that a company with growth potential is selling for a much lower price now than it could be in five or 10 years is the prime reason so many growth stock investors exist in the first place.
What's the best way to crack the code and pick growth stock winners? Let's take a look and see how to choose the best growth stocks.
Choosing the Best Growth Stocks
The first step in selecting good growth stocks for your portfolio is identifying their key characteristics.
For example, a good growth stock has some numerical performance qualities that separate them from other stocks. Growth stocks with price potential should have a three-year earnings growth rate of 15% or higher, and the industry the company resides in should deliver 10% earnings growth over the same time frame.
Here are some other defining characteristics of strong growth stock opportunities:
They Have Good Financial Fundamentals
A deep dive into a growth stock's financials can reveal a great deal about its share price potential.
That's where recognizing a growth company's fundamentals can help choose a winner. Any fundamental analysis growth stock research campaign should cover the following areas:
- The balance sheet. This shows the assets, liabilities, and capital of a company at a specific point in time, including the balance of the company's income and expenditure over the preceding period.
- Cash flow. A company's cash flow represents the net amount of cash flowing inside and outside of a business. Cash flow is key to a company's financial growth prospects, as its ability to generate sustainable positive cash flow is a good indicator of solid financial health and usually leads to share price growth.
- Income statement. A company's income statement is a basic document that shows a business's profit and loss along with a statement of earnings. The income statement is deemed by economists to be a company's most important fundamental financial document, as it reports the company's revenues, expenses, gains, losses, and the final net income for the company in a specific period (like a quarter or a year.)
Taken together, the above company financial fundamentals point to a company's ability to generate revenues, properly manage debt and possess the cash flow to grow significantly in the coming years, assuming the company's product or service remains in demand, and that the company is run by a strong management team, among other revenue-generating factors.
The Company Is a Trend-Setter
If you're at home watching Netflix or having a latte at Starbucks, as a consumer, you're already immersed in a trendsetting experience.
Netflix and Starbucks are good examples of growth companies that have established major trends largely on their own. Netflix invented the video streaming experience and Starbucks has immortalized the concept of chain-based gourmet coffee (as well as becoming a home office for millions of emerging freelance workers.)
Trends matter when it comes to vetting good growth companies and nobody is expecting you to accurately predict the next Netflix, Starbucks, or Amazon.com. But if you're actively involved in a cultural trend yourself, the company behind that trend stands as a strong example of a growth stock with more room to grow.
Potential trends you can latch into right now include the aging baby boomers heading into retirement, the ascension of technology game-changers like artificial intelligence and robotics, and burgeoning middle classes with money to spend in foreign markets like China, India, and Brazil.
The Company Is in a Valuable Niche
Does a company do one product and do it well? If so, it's ensconced itself in a profitable niche and stands to make a lot of money over a long period.
Think of Facebook (FB) - Get Report , which despite its myriad optics problems these days, still does social media better than anyone else, and is also growing into new areas like online dating, banking and finance, and retail sales.
Finding growth stocks in a great niche -- companies that excel at one thing and are emerging from the pack in doing so -- are companies that can turn a profit for years to come.
Any company that sells a product or service with a loyal customer base and that is pouring money into the research and development necessary to put a stranglehold on that niche is worth looking into as a potential growth stock opportunity.
The Company's Share Price is Trending Upward
Taking a closer look at a company's recent trading history can also a reveal growth stock winner.
For example, if an emerging company is showing a stock price history of higher highs and higher lows, that's a sign the company is trending upward with investors and might be ready to take off.
To gain a clearer insight into a company's trading patterns, leverage technical indicators like moving averages, which can help you drill down deeper into the micro-trends behind a growth company's share price.
Read Up on Growth Stocks
A good growth stock picker is an educated growth stock picker -- and vice versa.
Thus, digesting great growth investing books like "Benjamin Graham and the Power of Growth Stocks" by Frederick Martin and "One Up on Wall Street" by legendary fund manager Peter Lynch (maybe the greatest growth stock pickers of all time) can make you a better growth stock analyst - and you'll learn a lot more about the financial markets in the process.
The Takeaway on Finding Good Growth Stocks
Nobody ever said that finding strong growth stocks would be easy.
After all, you don't own a crystal ball and it's not always apparent that a company is set to become the next Amazon or Apple.
What you can do, however, is vastly increase your chances of finding good stocks by applying strong fundamental analysis, recognizing profitable trends, and learning as much as you can about how growth stocks work, and how the stock market works, in general.
Do that and you'll be parking some of the best growth stocks available in your investment portfolio sooner than you think -- and with substantial profit opportunities to follow.