It’s no secret that growth stocks have been pretty disappointing over the last two years. Not too long ago, these enterprises were full of promise, with roaring stock prices to reflect their potential. But in the face of rising interest rates and a massive economic slowdown, these lofty valuations have come crashing down.
With high potential gains comes more risk. And the recent downward volatility served as a perfect reminder that not every tech, biotech, EV, mining, or blockchain business is a unicorn.
However, among the shares that have been sold off lately, there are some that continue to fire on all cylinders despite what the stock price might suggest. And buying these high-quality enterprises while prices are still cheap could reap enormous returns in the long run. They might even help investors beat the market average.
Finding diamonds in the rough
I have a diverse collection of growth stocks in my ISA, spanning industries such as e-commerce, fintech, and cloud computing. Since these sectors were among those to be sold off aggressively, 2022 was a rough year. And yet I refrained from selling despite seeing many of my stocks moving in the wrong direction.
As a long-term investor, short-term volatility doesn’t bother me. There’s no denying the shift in monetary policy and interest rate environment will have an adverse impact on almost every business. However, for companies that produce an exorbitant amount of free cash flow (FCF), the rising cost of capital isn’t a big handicap.
Even among unprofitable technology companies, there are several firms generating cash like there’s no tomorrow. And one example from my portfolio that I’ve recently added more to is Datadog.
Obviously, FCF isn’t the only important metric to consider. Checks against a firm’s efficiency, liquidity and solvency, among others, are just as important. And qualitative traits like a talented management team and competitive moat are also crucial. But in my experience, FCF is a terrific starting point for quickly finding hidden gems in the stock market.
Achieving market-beating returns
Since its inception, the FTSE 100 has delivered an average return of around 8% a year. Across the pond, the S&P 500 has delivered gains closer to 10%. This level of wealth creation is more than sufficient to build significant wealth in the long term. In fact, investing £450 a month for 30 years at a 10% rate is all it takes to become a millionaire. That’s one of the main reasons why passive index investing is so popular.
But capitalising on discounted high-quality growth stocks right now could push these gains even higher in the long run. Even if snapping up bargains today leads to just an extra 1% in portfolio returns, that’s enough to roughly add another £250,000 to an individual’s net worth.
Stock picking, when executed correctly, can lead to stellar results. And it’s how billionaire investor Warren Buffett has achieved an average annual gain of nearly 20% since the 1960s. But it also comes at the price of higher risk. Investors need to be tuned into the threats to their businesses and be prepared for a potentially volatile journey.
But by keeping a cool head and focusing on the long run, tremendous wealth can be unlocked.
