How to invest in growth stocks

Michael Taylor identifies the key features to look for in growth stocks.

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Growth stocks have been hugely popular over the last 10 years as the market has roared on to consecutive new highs in what has been the biggest bull market of all time. 

For that reason, growth stocks have been in favour, and many investors have cashed in on the capital growth that many of these stocks can offer.

Here’s how to invest in growth stocks.

Find a growing market 

First of all, we need a growing market to find a growth stock to invest in. It is no good investing in a growth stock in an industry that is on its way out. Think of photography film or DVD rental.

We want stock in companies that have an expanding and growing market, in which they will be able to attempt to take a slice of the pie on offer.

Find a stock that is growing its revenues quickly 

We want stocks that are able to grow their top-line income. Stocks that can aggressively grow their business in the marketplace will see increases in revenue. While in the growth stage, profits are not so important as long as the business can expand and eventually turn those large revenues into profits. 

Companies that have a first mover advantage in a growing industry can be excellent growth company prospects, so long as the business can demonstrate high – and preferably accelerating – levels of growth.

Find a stock that is operationally geared

Stocks that benefit from operational gearing can be highly attractive growth investing candidates. Businesses that have fixed costs can see more and more of that revenue drop to the bottom line in profit when the business scales up. For example, a company that has a fixed-cost platform will need enough business to cover its costs. Once those costs are paid for, every penny of income then becomes profit, thus increasing the company’s margins.

Find a company that has a high ROCE

Return on capital employed (ROCE) is the company’s interest rate. If a business can invest £100 into its own business, and in return receive £120, then we would say that the business has a ROCE margin of 20%. Given that compound interest works exponentially, the company could then reinvest the proceeds into the business and grow even faster. 

Find a business that is light on capital expenditure

Companies that do not require high amounts of capital expenditure on the maintenance side can grow incredibly quickly. Businesses that require heavy capex spend on things like machinery and equipment must spend in order to keep their business afloat, rather than pump that cash into further growth. 

By identifying businesses that fit these parameters, there is a good chance that you have found an exciting growth stock. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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