Growth investing has been extremely profitable with growth funds for example Cathie Wood's ARK Innovation ETF (ARKK) surging over 200% over the last year.
The performance of growth funds happen to be attributed to disruptive growth stocks that can take advantage of opportunities from record-breaking technological changes. These companies have the potential to change their industry's landscape by creating simplicity and accessibility while driving down costs with their technologically enabled product or service.
The current pullback we are seeing in the market presents an attractive buying opportunity for long term investors looking to gain exposure to these disruptive growth stocks. Today, we will explore the characteristics of growth stocks and discuss the way we can identify top growth stocks that are revolutionizing their industry.
What is really a growth stock?
Growth stocks are firms that increase both their revenue and earnings quicker than most stocks within their industry. These companies are able to generate exponential growth by developing an innovative product or service that is able to gain share of the market from its competitors or creating entirely new industries.
These high growth stocks are rewarded by the market, delivering huge returns to shareholders in the process. The faster their growth, the bigger their returns.
In contrast with value stocks, high growth stocks are relatively more expensive with a higher price to earnings ratio (P/E Ratio) and value to sales ratio (P/S Ratio). However, despite the fact that growth stocks are expensive relative to the current earnings, the best growth stocks can continue to provide huge returns to investors when they realise their growth potential.
How do we find growth stocks?
With thousands of stocks to choose from, how do we identify the best growth stocks to purchase 2021?
We can use a screening tool, to scan thousands of stocks in the market and filter stocks with strong revenue growth. Using this list of fastest-growing stocks today, we operate a fundamental backtest to further select the top growth stocks for our portfolio. Finally, qualitative investors may also further enhance the selection of growth stocks using fundamental analysis.
Screening for our universe of growth stocks
Head to the screening tool where we are screening for our investment universe of growth stocks.
In our screen, we will be filtering for:
- Stocks in the US market
- Stocks that are mid cap sized and above
- Stocks with a revenue growth greater than 20%
In the Region field, select US Stock. Under Market Cap, check the mega cap, large cap and mid cap checkboxes. Click Add another filter and choose revenue growth. A new revenue growth field can look where we will select stocks having a revenue growth greater than 20%. Finally, click on the blue button to find your stocks.
This will generate a list of over 500 stocks that pass our screening criteria. Within the list, we can see stocks for example Apple that had revenue development of 21.4% in the last year. Click on the button to create a backtest with screen results.
You will see a pop up with the option to produce a backtest using your screen results. We will select the top 250 stocks from your screen results with the highest revenue growth to operate a fundamentals backtest. Once you have selected these parameters in the dropdown menus, click on the blue button to create your fundamentals backtest.
Backtesting our growth investing strategy
You will be directed to the fundamentals backtest page, in which the investment universe has been pre-populated with the 250 stocks from our screen with the highest revenue growth.
Scroll down to the next section, where we will select the signals for our fundamentals backtest to construct our portfolio of top growth stocks.
We are going to select 3 signals to rank our stocks – revenue growth, profit growth and value to sales ratio (P/S ratio). Besides, using growth metrics for example revenue growth and profit growth to decide on the fastest growing companies, we also want to look at valuation to make sure that our stocks are not excessively overvalued in accordance with their sales.
We use the price to sales ratio instead of the price to earnings ratio (P/E ratio) because a number of these growth information mill not profitable yet. They're spending a lot of money on areas such as marketing to increase their growth. Because their earnings are negative, their P/E ratio isn't defined. Hence we use the price to sales ratio to gauge the business's valuation relative to their sales. We want companies with the lowest price to sales ratio since they're cheap relative to their sales with strong upside potential.
These signals are normalized so that they are comparable with each other and assigned a weight of 33% each where we equal weight all these signals. These signals are combined together to form our overall signal used to rank all 250 stocks in our investment universe allowing us to decide on the best growth stocks for our portfolio.
Next, select the number of stocks to include in your portfolio. We are going to select 30 stocks within our portfolio where each stock is every bit weighted at 3.3%. This really is to ensure that our portfolio is diversified with low concentration risk. We are not gambling on a single stock rising big. Instead, we are betting that growth stocks typically are able to outperform the market.
Our rebalance frequency is going to be set to a monthly frequency to prevent excessive trading and reduce transaction cost. Each month, 250 stocks will be ranked using the signals we selected (profit growth, revenue growth and value to sales ratio) and the top 30 stocks will be selected to form our portfolio.
Finally hit the run backtest button to operate your growth investing strategy.
The strategy has an annualized return of 32%, a volatility of 25% and a max drawdown of 39%.
Comparing the strategy against Cathie Wood's ARK Innovation ETF (ARKK), we can see that there is a significant correlation within their performance. This is due to similar exposure to growth stocks between the 2 strategies. While ARKK includes a higher annualized return of 34%, our strategy has a higher risk-adjusted return reflected from the higher Sharpe ratio (1.08 vs 0.99).
Scrolling down, you will notice a list of stocks in the strategy's current portfolio and also the weight of each stock within the portfolio. These are the top growth stocks selected by the model based on the signals we chose for the growth investing strategy.
For quantitative investors preferring relying on a fully systematic strategy with no human intervention, you can choose to invest in all 30 stocks from your backtest portfolio.
Fundamental analysis of growth stocks
Qualitative investors who prefer looking at the business model and growth potential of a stock can do additional fundamental analysis to help narrow down this list of 30 stocks down to 15 to 20 stocks.
One possible way to analyze these stocks is to find stocks that are best positioned to profit from strong market trends. Companies that are able to take advantage of these trends can exponentially grow their profits, generating huge returns for investors.
For example, one of the stocks selected by our model was Fiverr. Fiverr is really a global online marketplace for freelancers in creative industries. Freelancers give a wide number of services such as developing a new website, creating a new logo, editing a relevant video and writing for blogs. With the huge tailwinds due to the work from home trend and also the gig economy expected to grow to $100b in america market, Fiverr's revenue growth has been accelerating to over 80% year over year.
Another approach to analyzing stocks would be to search for companies with strong economic moats that can maintain their competitive advantage and protect their profits and share of the market from their competitors.
A great example of such a company selected by the model is CrowdStrike. CrowdStrike is a growth leader in cybersecurity with a disruptive business model in endpoint security. CrowdStrike uses artificial intelligence to learn from previous cyberattacks, allowing its platform to adapt and provide robust cybersecurity solutions. The business's superior technology is a strong economic moat that creates an effective barrier against its competitors, preventing them from seizing their market share.
Investing in growth stocks can be extremely profitable for long term investors looking to participate in the exponential growth of disruptive companies. We discussed how to build a portfolio of top growth stocks utilizing a screening tool and a fundamentals backtest. We looked at how qualitative investors can further narrow the stock selection using fundamental analysis. Hopefully that you will be able to use this stock-selection approach to profit from growth investing.
Happy investing, and could the odds be in your favour.
Ivan may be the founder of PyInvesting.com. He is passionate about technology and finance and it has worked as a software developer in a hedge fund where he was accountable for building the fund's trading system. He hopes that PyInvesting can help investors adopt a data-driven method of investing and support them in their journey towards financial freedom.