A growth stock is a share in a company whose earnings are expected to grow at an above-average rate relative to the market.
A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Growth investors choose stocks based on the potential for capital gains, not dividend income, so they can be risky.
Technology companies are typically good examples of growth stocks because the opportunity for advancement is virtually limitless. However, growth stocks also carry a lot of risk because shareholders rely solely on the company’s success to generate return on their investment. If the company’s growth is not what was expected, shareholders may end up losing money as market confidence wanes and share prices drop.
Characteristics of Growth Stocks
While many promising small-cap stocks may be considered growth stocks, not all growth stocks are issued by small companies. One competitive advantage that is common among growth stocks is manufacturing scale. Because producing many items is typically cheaper than manufacturing just a few, the economies of scale enjoyed by larger companies often mean that they can keep more of their revenues as profit, accelerating growth.
Growth stocks also often share a few other common traits that are independent of company size. Growth companies typically either have a very loyal customer base or a firm grasp on the majority market share. This could mean that the company is the first to offer a given product or service (likely a smaller company in a newer industry), or that it is simply the most popular company among many (a large company dominating its market).
Growth companies also typically have unique or advanced product lines. A growth company may hold a patent for a new and promising technology or product or have a history of being at the forefront of industry developments. This is the primary reason that growth companies do not pay out dividends. The company’s goals are best served by reinvesting its earnings into product research and development, thereby fueling expansion.
Growth vs. Value
The distinction between growth and value stocks is very important in investing. While growth stocks are those that are anticipated to generate substantial capital gains, value stocks are those that the market sees as underrated or ignored. Growth stocks are often overvalued because the market sees them as money-makers. Value stocks, by definition, are undervalued.
While value stocks may be under-priced due to disappointing earnings reports, negative media attention, or legal troubles, they still have good financials and a solid dividend payout history. A consistent dividend track record is crucial to a value stock as it is this reliable investment income that tells investors the stock is worth buying. Value stocks are rarely glamorous and are often older companies that, while they won’t be going anywhere soon, aren’t exactly on the cutting edge of industry innovation.
Typically, prudent investors hold a combination of growth and value stocks to capitalize on the benefits of both investment types.