What is growth investing?

Growth investors don’t particularly care about the current stock price as long as the company or sector looks poised to march higher. It’s the potential for lottery-like returns that appeals to growth investors.

When it comes to growth sectors, technology is usually the first to come to mind. Tech stocks have been at the front of the pack for investment returns over the past decade, but other sectors cycle in and out of favour and can also produce eye-popping returns in times of growth. Energy stocks, for example, slumped for many years but have rallied this year on rising oil and gas prices.

Budding industries like cannabis, FinTech, clean energy, 5G and biotechnology offer mouth-watering potential to produce the best-performing stocks over the next decade or more.

Since the brief market crash in March 2020, we’ve seen some incredible growth stories across a variety of industries. Tesla’s stock price is up 819% since March 2020. Canadian software company Lightspeed Commerce has seen its stock price soar 708% in the same period. Meanwhile, meme-stock darling GameStop has returned an unbelievable 4,496%.

It’s not always so rosy for growth investors. Growth stocks can be incredibly volatile. Look at the fitness company Peloton, which saw its stock price shoot up 395% in 2020 but it is now down 43% in 2021. Zoom Video Communications has a similar story, growing by 401% in 2020, only to see its stock price fall 24% so far this year.

How to choose growth stocks

Growth investing is all about identifying companies or sectors with the potential to produce strong returns compared to their peers and the overall market. Metrics like price-to-earnings or price-to-book, which are key fundamentals when hunting for value stocks, tend to be ignored when screening for growth stocks. Instead, a growth investing strategy might look for high earnings-per-share growth along with short-term trend signals like a stock price’s momentum over the past 90 days.

Unlike value investors, who are happy to buy stable blue-chip companies that produce goods we all know and love, growth investors are more apt to take a chance on an up-and-coming stock or sector that’s primed for explosive growth.

Investing in large cap growth stocks has paid off handsomely over the past decade. But it’s a mistake to think that outperformance will continue for the next 10 years or more. Research from 1930 through to 2010 looked at the 10 largest companies at the start of each decade and found that the average annual returns of those companies trailed the market by 1.51% per year over the subsequent decade. This underperformance makes sense when you consider the powerful concept of mean reversion: An asset’s price tends to converge to the market’s average price over time.

The massive success of large cap growth stocks over the last decade is surprising, when you consider the abundance of academic evidence that supports stronger returns from small cap value stocks. The Fama-French five-factor asset pricing model, for example, suggests there is a risk premium for small stocks over large stocks, and for value stocks over growth stocks. But that premium hasn’t been seen for many years.

Indeed, large cap growth stocks in the U.S. produced total returns of 174% in the five years ending October 5, 2021. That’s an impressive 22.32% annual return. U.S. small cap value stocks, on the other hand, delivered total returns of 70% over the same five-year period, for an annual return of 11.21%.

Finally, consider the volatile nature of growth stocks, with their potential for explosive short-term returns but also steep short-term declines. For growth investors, that means constantly monitoring their portfolio and finding new ideas when hot stocks or sectors are in decline.

Reduce volatility risk with ETFs

If picking individual growth stocks sounds too much like guesswork, then it could be sensible to use thematic or sector exchange-traded funds (ETFs) to make your bets on growth. These funds are typically governed by rules and methodologies that tell fund managers when to buy and sell the stocks they contain. That takes decision-making away from the individual investor, which is usually a good thing.

For instance, a “core and explore” investing strategy might allocate 90% of a portfolio to broad-market index funds and the remaining 10% to more speculative growth opportunities in emerging sectors like technology, clean energy or biotechnology.

For the “core” component, investors could consider Horizons NASDAQ-100 Index ETF (HXQ), one of the lowest-cost NASDAQ-100 index ETFs listed in Canada. It offers direct exposure to the NASDAQ-100 Index, which is made up of equities issued by 100 of the largest U.S. and international non-financial companies listed on the NASDAQ Stock Market. HXQ includes familiar company names like Apple, Amazon, Alphabet, Facebook and Netflix.

Growth-minded investors considering an “explore” sleeve can purchase shares of an ETF that invests in the building blocks of big data, like Horizons Big Data & Hardware Index ETF (HBGD). The ETF provides exposure to global companies focusing directly on big data through blockchain and cryptocurrency innovation and development, as well as companies providing hardware and hardware-related services used in the process of mining. This approach removes the guesswork of picking future winners.

Every sector has its own index-tracking ETF, making it easy for investors to take a flyer on a growing industry that’s poised to break out.