Growth Stock Trading Strategy (Backtest And Example)
Last Updated on December 30, 2022
When it comes to investing, there are many strategies you can adopt. And if you want to make your money work harder, it’s important to choose the right investment approach.
A growth stock trading strategy is a method of stock investing that focuses on companies that are expected to grow at an above-average rate compared to their industry or the broader market. While the growth stock trading strategy has the potential for high returns, it can be very risky. Careful research and analysis of companies’ fundamentals are important.
In this post, we take a look at the growth stock trading strategy and we end the article by doing a backtest to see how growth stocks have performed.
What is a growth stock?
A growth stock is a publicly traded company that is expected to grow at a faster rate than the average growth for the market. Such stocks often tend to pursue growth by reinvesting their earnings into research and development or expansion into other regions and markets. As such, they do not often pay dividends until after they have attained a certain milestone.
Growth stocks are mostly small-cap stocks from new companies, but some larger companies may also be growth stocks if they are innovative and continually expanding into new areas of business that drive growth — examples of such big companies include Amazon, Microsoft, and Apple. When investing in growth stocks, the expectation is to earn money through capital appreciation when the stocks are stocks in the future.
The “opposite” of growth stocks is value stocks (more about this later).
Growth stocks tend to share a few common traits, such as the following:
- They tend to have low earnings or may not have earnings at all at the present as they are investing in growth
- They tend to have a high price-to-earnings (P/E) ratio
- They tend to have unique product lines and may hold patents or have access to technologies that put them ahead of others in their industry.
- In order to stay ahead of competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer-term growth.
What is a growth stock strategy?
A growth stock trading strategy is a method of stock investing that focuses on companies that are expected to grow at an above-average rate compared to their industry or the broader market. It is the idea of buying only fast-growing companies that retain their earnings to pursue growth, in hopes of outsized returns in the future·
Growth investors tend to favor smaller, younger companies poised to expand and increase profitability potential in the future. Those are often new companies in emerging markets and innovative industries, like high-tech. While growth stocks have the potential for high returns, they can be risky. Thus, it is important to make careful research and study the company’s fundamentals and ability to stay competitive.
A growth stock example
An example of a growth stock would be a company that develops new technology and is the first to provide a new service. Such a company would gain a lot of market share very fast for being the only company providing a new service. If other companies later enter the market with their own versions of the service, they may struggle to take market share from the first company. If this company manages to attract and hold the largest number of users for that service and keeps innovating to stay competitive, it would be considered a growth stock.
For example, Amazon in the early 2000s was a new growth stock with the potential for huge returns. It delivered massive returns in the long run. A $1000 investment in 2001 would have yielded over a million dollars by 2021. Even up to this moment, Amazon is still considered a growth stock because of the way it innovates and expands into other business areas.
Similarly, Tesla in 2012 is another mighty growth stock. Despite the growth over the years, Tesla still has a lot of room for growth, so it is still a growth stock.
However, while Amazon and Tesla went on to perform well, most of the growth stocks end up in the graveyard. You have to be very careful so as not to be liable for survivorship bias.
Growth investing vs. value investing (evidence)
There are many ways growth investing differs from value investing. These are some of them:
- Earnings: In growth investing, investors are interested in a company’s potential for growth and may not bother much about the current earnings, as long as the company’s business model can make profits in the future. Value investing, on the other hand, seeks to buy stocks at a discount so it aims to capture stocks with good earnings that are wrongly underpriced (undervalued).
- P/E ratios: Growth investors don’t bother much about high P/E ratios, as they focus mainly on a stock’s ability to appreciate significantly due to strong growth in the underlying company. Value investors, on the other hand, use the P/E ratio to assess how expensive a stock is and whether it is overpriced or underpriced.
- Dividends: growth investors are not usually interested in dividends, but value investors might consider it when choosing a stock to invest in.
Growth investing pros and cons
Some of the merits of growth investing include the following:
- There is a chance for massive returns if you pick the right stocks
- It’s a good way to support start-up companies
Despite the advantages, growth investing has its demerits, which include:
- The investment risk is high, as not all growth stocks would end up competitive. Actually, most growth stocks end up in the graveyard.
- There is no dividend income
Growth stock trading strategy backtest
Let’s look at the performance of value and growth stocks. Throughout the rest of the article, we use the ETF with the ticker code IWD as a proxy for value stocks and IWF as a proxy for growth stocks. These are the ETFs of Russell 1000 Value and Russell 1000 Growth.
If we look at the performance/CAGR of these two ETFs since their inception, we can see a winning strategy:
- Russell 1000 Growth: 5.62%
- Russell 1000 Value: 6.39%
The 0.77% difference might sound very small, but over time such a difference adds up!
One other issue is that growth stocks are more volatile than value stocks. Look at the chart below that displays the performance of IWD and IWF since inception:
Both during the bear markets of 2000-2003 and 2022 we see that growth stocks fall much more than value stocks. This is to be expected because growth stocks are much more dependent on future earnings than value stocks. When investors start discounting weaker future growth, then growth stocks fall hard.
Because of increased volatility, retail investors tend to underperform the broad market indices. They buy high and sell low – the opposite of what is rational. The fact is that most stocks go on to perform poorly and this is what makes stock picking so difficult. And, to be frank, this is even more difficult among growth stocks.
(We don’t have a specific growth stock trading strategy backtest. It’s hard to label a growth stock from a non-growth stock, and we are at a loss for what kind of trading rules to use.)
FAQ growth stocks strategy
Let’s end our article with some frequently asked questions about growth stocks:
- What is a growth stock?
A growth stock is a stock that has the potential for above-average price appreciation. Growth stocks typically have higher price-to-earnings (P/E) ratios than their peers and are more likely to be found in the technology, healthcare, and consumer goods sectors. However, the survival rate among growth stocks is low. It’s extremely difficult to pick stocks. Most retail investors are better off investing in a passive mutual fund or ETF. - What are the advantages of investing in growth stocks?
Growth stocks have the potential to generate higher returns than the broader market, and they can provide investors with capital gains as well as dividend income. But it comes with a caveat: higher volatility in the returns. - What are the risks of investing in growth stocks?
Growth stocks may be more volatile than the broader market, and they often have high P/E ratios that can make them more vulnerable to price declines. Additionally, growth stocks may be more vulnerable to economic downturns or changes in consumer tastes. Any high PE stock might suffer enormously if the market changes its mood and decides to price the stock with lower multiples. - How do I identify good growth stocks?
When identifying potential growth stocks, investors should look for companies with strong fundamentals, such as consistent earnings growth, high return on equity, and low debt levels. Additionally, investors should consider the industry in which the company operates, as well as the company’s competitive position and potential for future growth. That said, stock picking is often a fool’s errand. The great majority of retail investors underperform the main indices by a wide margin. - How do I determine if a growth stock is undervalued?
In order to determine if a growth stock is undervalued, investors should compare the company’s current price-to-earnings (P/E) ratio to its peers and the broader market, and especially compared to its own historical average. - How should I diversify my portfolio if I’m investing in growth stocks?
When investing in growth stocks, it is important to diversify your portfolio by investing in a variety of stocks in different industries and sectors. Additionally, investors should consider investing in other asset classes, such as bonds, real estate, and commodities, in order to reduce risk. The average retail investor should always make sure they are very diversified. - Is growth investing a good strategy?
That depends. As mentioned earlier, growth stocks tend to go from pessimism to optimism and thus the swings can be brutal. Growth investing is not for the faint of heart. Any retail investor MUST diversify their holdings.
List of trading strategies
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