The Vanguard Growth Index Fund ETF is down around 20% since the beginning of the year. Compare that to its counterpart, the Vanguard Value Index Fund ETF, which has slipped just 1.64%, and it’s easy to see why investors who have been staying away from growth stocks are suddenly feeling good about themselves.
When stocks fall sharply, it can sometimes be a great opportunity. But it can also be a sign that previous prices were unjustifiably high. So are growth stocks now a bargain? Or do they have further to go?
Investing in growth stocks
Buying shares in a company involves taking a partial ownership in the business. And the return on the investment comes from a company’s earnings.
Let’s compare two companies. Five years ago, Coca-Cola (NYSE:KO) shares sold for $43.15 and the company produced $1.49 in earnings per share (EPS). By contrast, shares in Amazon.com (NASDAQ:AMZN) sold for $925 and the company generated EPS of $4.90.
On the face of it, Coca-Cola stock was a much better investment five years ago. Coca-Cola shares were offering an annual return of 3.45%, whereas Amazon.com shares were returning just 0.53%. But it’s not as straightforward as that.
Coca-Cola now makes $2.25 in earnings per share. Over the last five years, it has produced a total of $7.9 per share, which amounts to a return of 18.3% on an investment made in 2017. By contrast, Amazon.com now makes $64.81 on a per share basis and has produced $160.84 in EPS over the last five years, giving a return of 17.39%.
Amazon is an example of a growth stock. At current levels, returns on growth stocks are very low. But the idea is that they will increase their earnings to produce strong returns for investors over time.
Risks with growth stocks
A lot can go wrong with growth stocks. First, the anticipated earnings might not materialise. If Amazon’s earnings per share had never risen above $5, then the investment return would have been terrible.
Second, an investor can overpay for a growth stock. If I’d paid $3,000 for a share in Amazon five years ago, I’d have had a very unsatisfactory return despite the growth in the company’s earnings.
The sharp fall in growth stocks has been the result of both risks materialising together. In recent earnings reports, companies like Netflix and Meta Platforms have suggested that their anticipated growth may be lower than expected.
Equally, rising interest rates have caused some investors to think that they might have overpaid for growth stocks in the first place. As interest rates rise, the attractiveness of companies that currently produce low earnings decreases.
This brings us to the question of whether there are opportunities in growth stocks at the moment. My view is that there are, but I’m looking to tread carefully and be selective in the opportunities that I’m taking.
One growth stock that I like very much at the moment is Guidewire Software. The price of its shares has declined substantially over the past six months, but the underlying business still seems to be growing well. As a result, I’m looking at buying shares for my portfolio as the general sentiment against growth stocks remains negative.
