I fear for those who will be reliant on their state pension when they retire in 20–30 years, because I don’t think it will exist by then. Given the high rate of human population growth and rising global debt, I just don’t see how anyone could be confident about it.
That’s why I took action early on. In my twenties, I made the decision to start investing. But more than that, I made the decision to start investing in growth stocks.
Why you should invest in growth stocks
Growth stocks are all about capital growth. You don’t choose them for dividends or income, but because you want your investment to grow in value. However, growth stocks also tend to come with higher risk; growth stocks can have insanely high price-to-earnings (PE) ratio valuations. Growth stock companies can also be at risk from many other factors simply because they are smaller and younger than large, established industry monoliths. It’s easier to for them to be knocked off-course.
But, it’s also easier for them to navigate stormy waters. Whereas a FTSE 100 giant may struggle to adapt to market trends due to its size, a much smaller growth company may be more nimble.
For those who can afford to take on a bit more risk before they retire, it makes sense to consider growth stocks.
Growth at a reasonable price
Growth at a reasonable price (GARP), as it was called by Peter Lynch, is a strategy that looks for attractive growth businesses that aren’t valued at lofty P/E ratios. Lynch, a former Fidelity fund manager, also used the price-to-earnings growth ratio (PEG) for valuation. This looks at the P/E ratio against the percentage growth rate of a company. For example, a company that is growing its earnings at 40% a year but is rated by the market on a P/E ratio of 20 times earnings would be classed as cheap due to a PEG ratio of 0.5.
Self-sustaining business models
One big problem of growth stocks is that they can be cash-guzzling and loss-making. That means that more cash is often required, from new shareholders, which dilutes the entire issued share capital. Existing investors don’t like to see their percentage shareholdings in the business dwindle, so the market’s reception of these fund raises can be extremely harsh if management doesn’t plan ahead.
That’s why I believe it’s important to look for growth stocks that are have attractive PEG ratios but that also have self-sustaining business models. This reduces the overall risk of investing in growth stocks. A company that doesn’t need external sources of funding to keep the lights on is a lot safer than one that does!
One final factor that I like to see in a growth company is management owning plenty of shares. It’s much better for directors to be aligned with shareholders (preferably with their own skin in the game) than for them to have no equity or interest in the business’s success.
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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.