Growth investing

June 5, 2015 / Investment Ideas

Growth investing is purchasing equities based on their expected future value. This is a speculative form of investment because no one is able to accurately predict the future value of a company, especially the equity price of a smaller company. Such growth equities are sometimes known as small caps, and they have potential for huge returns on capital (and of course the possibility to not do as well as expected).

In simple financial terms, future value is equal to present value times the rate of growth:

Present Value   x   Rate of Growth   =   Future Value

The present value is the current share price, which is easy to know. The future value is also easy to know… if we know the rate of growth (which is impossible to accurately predict).

Most people think of high technology start-ups when they think of growth investing since these are the types of companies which have a lot of media coverage. You can always read about new start-up companies with only a few employees and no profit which has an incredible initial public offering or is acquired by a larger technology company and the early investors get very rich. This is exciting and gets more readers to click on the news story, but it’s not what most growth investing is about.

There are many publicly traded companies (equities) which are smaller and not necessarily covered by analysts. Most investing is done by large institutions such as pension funds which need liquidity for their equity investments, which means they prefer to hold well-known and well researched companies. This means that larger companies will usually trade at a much higher price than smaller companies in comparison to the company’s earnings because there will be much more demand for them.

Small cap equities which have little coverage and little attention can be very inefficiently priced, which means small company equities can be purchased at very cheap prices. Over time, small cap equities beat large cap equities because they are unknown to the general public. These are equities which double, triple, even quadruple in value for an investor over the years. With growth equities, this happens all the time. In fact, all most every great large cap equity was originally a small cap equity.

If you can make such huge profits with growth investing, does this mean you should invest all your money into growth equities? No. The potential for huge growth also means there is potential for huge losses. It is very easy to identify good investments in hindsight, but much harder to identify which small caps will make you rich. The key to growth investing is to diversify holdings amongst good small cap equities purchased at good prices.

Growth investing should only make up a smaller part of your overall portfolio, with the actual allocation rate depends on your risk tolerance. This will reduce the chances of a loss seriously impacting your portfolio, while still having the some potential for huge gains.