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Love investing in growth stocks?

This post was originally published on this site

There’s a range of high-flying growth stocks to invest in that are world-changers in their respective industries.

I just wanted to share a few ideas, just off the top of my head on growth-investing.

Growth-investing usually involves investing in innovative, game-changers. These companies are disruptors to an industry or are rapidly gaining control of a certain market. They are able to draw market share quickly given their disruptive business models. Earnings growth out of these companies are usually very high. This is because they continually grow their base and penetrate different spaces as well as have strong pricing-power. As a result, they usually trade at relatively high P/E multiples and can appear to be expensive. These shares can stay expensive or get more expensive, but only if they keep delivering or exceeding earnings growth expectations and as long as the market can believe in the new initiatives that they undertake. Several of these companies’ management teams may have a strong track record of execution and deliver on this to the market year-by-year.

As a result, the “E” in P/E keeps going up and the share price or the “P” responds by an upward rerating. Great returns then materialise. This is lovely. These companies are lovely. They are usually nice to talk about and “sexy” shares to invest in. I love some of these businesses and invest in some of them myself, but I just want to highlight that this investment strategy is not without risk.

Because these businesses can appear to be “priced-for-perfection”, a slight miss on an earnings release or an external headwind, can result in their share prices derating aggressively. Remember, the “P” also responds in the opposite way when these companies don’t deliver on “E”.

Five or 10 years of these companies earnings either meeting or exceeding expectations, has probably resulted in their share prices responding in an upward direction year-by-year. You can only imagine what happens when they have one disappointing result!

Yes they are great businesses.

Yes they have changed the world.

But the market tends to price growth phases of these companies into perpetuity.

This is a risk.

Yes, they may very well keep growing, but as the years go, so too does their level of innovation need to. Some segments of the business can plateau and reach its maturity as penetration levels into certain markets reach its peak. That segment can then become a vanilla-business afterward. You are then banking on new areas of growth to keep that share price momentum that you’ve got accustomed to over the last many years.

Is it possible? Certainly, but it is not without risk.

Growth shares can do well for  five or 10 years and then in a year or two, several of those gains can all be erased. This is a reality when investing in growth shares. They are susceptible to aggressive deratings in their prices over fairly short spaces of time. This risk must be considered carefully when investing in growth stocks as it can have a material impact on investor returns.

Preston Narainsamy is portfolio manager at Nedbank Wealth.