Lesson 21 of 43 (Growth Investing): A Step-by-Step Guide to Picking the Best Growth Stocks

  • Growth stocks are companies that are expected to have unusually high growth in their future sales and/or earnings.
  • Growth stocks shine during bull markets as they’re buoyed by a strong economy and bullish investor sentiment; but the right growth stocks can also be surprisingly profitable during times of slowing economic growth or even bear markets.
  • We outline two very different types of growth stocks, one which most investors flock towards (but often performs poorly) and a lesser-known type of growth stock that performs much better.
  • We walk through a step-by-step guide to finding the best growth stocks, including screenshots and direct links to a stock screener that’s pre-filtered for high-potential growth stocks.

Welcome to the premium levels of the “How to Invest in Stocks” course!

By attending Levels 4-6, you’ve taken a HUGE step towards growing your investing knowledge and profits.

In these 20+ premium lessons, we’ll cover everything from how to find the best stocks, to when to buy and sell, to our golden rules of investing, and MUCH more.

In the next six lessons, we’re going to walk you through a step-by-step guide on how to find the best growth, value, small cap, large cap, dividend, and blue chips stocks (with screenshots and pre-filtered custom stock screens).

Starting with today’s lesson on growth stocks, we’ll outline four important concepts for each type of stock strategy:

  1. What are growth stocks?
  2. What should you know about investing in growth stocks?
  3. Which growth stocks perform best?
  4. How do you find the best growth stocks to buy? (A step-by-step guide)

At the end of these six lessons, you’ll have a deep understanding of how to pick the best growth, value, small cap, large cap, dividend, and blue chips stocks.

In addition, we provide a high-quality “cheat sheet” (downloadable PDF) that captures how to research all six types of stocks in a quick and handy one-sheet for your reference. 

Let’s begin by getting a basic understand of what exactly is a “growth stock” and why do investors buy them?

What Are Growth Stocks?

In general, growth stocks are companies that are expected to have unusually high growth in their future sales and/or earnings.

Investors who buy growth stocks often believe the company will deliver strong financial results far into the future as it finds an ever-expanding market for its products.

There are several key metrics that growth investors look for (which we’ll cover in detail below), but the bottom line is that growth investors seek out companies that have a long runway for fast sales and earnings expansion.

What Should You Know About Investing in Growth Stocks?

Growth stocks tend to perform best during bull markets for two main reasons:

  1. When the economy is growing and everyone is feeling confident, consumers, businesses, and governments are more likely to spend on products and services. So a strong economic environment tends to drive sales for good growth stocks.
  2. During bull markets, growth investors often quickly buy up shares of companies that show they’re riding a strong wave of growth. This bullish investor behavior can drive growth stock prices even further upwards. 

So, for several reasons, growth stocks shine bright during strong bull markets.

That said, growth stocks can also be surprisingly good investments during times of slowing economic growth or even bear markets.

When the economy is struggling and consumers, businesses, and governments lack the confidence to spend big, the growth companies that can maintain strong positive revenue and earnings momentum clearly have something special.

Whether it’s a loyal customer base, a sticky product, or a savvy management team, growth stocks that can keep financials headed up when the rest of the world is headed down tend to perform very well during hard times. 

One aspect of investing in growth stocks is that they tend to be a bit more volatile than other investment strategies (such as high dividend or value stocks).

Because investors are so focused on the company’s growth, strong financial performance can send a stock soaring while weak performance can send it tumbling.

And because many investors love to follow growth stocks, there’s a bit of a bandwagon effect from both investors and the financial media when a company comes up short during an earnings report.

For example, this is the type of headline you’ll often encounter if you follow a growth stock:

“Growth Stock Beats on Top and Bottom Line, Trims Guidance Next Quarter, Stocks Tumbles After Hours”

In this imaginary example, the growth stock has just beat analyst expectations for revenue and earnings in the latest quarter, but reduced its forecast for the current quarter.

Despite the strong reported financial performance, investors have smelled a whiff of slowing growth and quickly punished the stock.

Because investors are hyper focused on the growth stock’s upward momentum they’re often quick to bail at the first sign of slowing growth.

Compounding the volatility is the fact that growth stocks are often overvalued.

Because investors get so excited about their prospects, growth stocks tend to get bid up until the first sign of bad news, at which point the valuation and stock price come crashing back down.

Now, while all of the above is true for growth stocks overall, we think there are actually two VERY different flavors of growth stocks, and it’s important to understand the difference between them.

Let’s review the difference between what we call “story growth stocks” and “steady growth stocks.”

Which Growth Stocks Perform Best?

When investing in growth stocks, we believe it’s important to understand the difference between the two main types:

A story growth stock is when investors believe the company is going to grow very rapidly over the next 5-10 years and somehow substantially disrupt or take over an industry.

With story growth stocks, the price is often tied more closely to the belief that the company will have an incredible future than to the fundamental reality of the company today.

Story growth stocks often have a few risks associated with them:

  • First, they often have strong sales growth without being profitable. While revenue growth can be a powerful sign of product-market traction, it can also be the equivalent of selling one dollar bills for 90 cents – you’ll book lots of sales, but also huge losses.
  • Second, story growth stocks are often highly volatile. With little to no profit, they’re difficult to value. As a result, their price can swing wildly based on revenue changes, news, speculation, and market perception.
  • And lastly, story growth stocks are often considered highly overvalued. Sure, if they end up dominating their industry, they may actually be a bargain right now. But too often they’re essentially a business that currently loses money (or makes very little) and it’s hard to value that type of stock. As a result, they’ll often have very high P/E ratios and be priced based on future potential rather than current reality.

Another flavor of growth stock is the steady growth stock. These stocks deliver steady above average sales and earnings growth year after year. They may not have an incredible future upside like story growth stocks, but they have found a formula for steady profitable growth and can often deliver through good times and bad.

A good example of a steady growth stock is Apple (AAPL). They have delivered an average of 8% sales and earnings growth per year over the last five years, all while buying back shares and boosting their dividend by 45% per year over the same period.

Does Apple have the potential to completely take over the consumer electronics industry and double, triple, or quadruple is size? No, that already happened. The stock has gained nearly 1,300% over the last decade (not including dividends) and already dominates the consumer electronics space.

So Apple isn’t really a story growth stock anymore, because investors don’t dream of an incredible future where the company has grown 10x bigger. But they’re a great steady growth stock with beloved products that are riding a wave of worldwide growth in demand for personal devices.

When it comes to growth stocks, both story growth stocks and steady growth stocks can deliver incredible profits over time.

Based on our research and experience, story growth stocks are more exciting, but steady growth stocks tend to deliver more often and much faster.

In addition to differentiating between story and steady growth stocks, our research suggests buying fairly valued (or undervalued) growth stocks can substantially improve your profits.

Because growth stocks tend to get bid up during strong bull markets by investors hoping for bigger and faster growth, their valuation can get detached from reality.

By looking for growth stocks that are both growing steadily AND not overvalued, you can own growth stocks with less risk.

In fact, a popular investment style that uses this strategy is known as “Growth at a Reasonable Price” or “GARP” for short.

Finally, smaller growth stocks tend to offer greater upside than larger growth stocks. This is mainly because they have much more room to expand into the market.

As discussed above, Apple has shown fantastic long-term growth, but there isn’t a lot more room for iPhone expansion in the global market.

But a small cap or mid cap electronics company might be fighting to capture just 1% of global market share. Their product, and their stock price, has a much longer runway for potential growth than a big company that has already expanded worldwide.

If you’re more interested in predictable, low-risk, growth stocks, you may want to focus on large cap stocks. However, if you’re interested in finding undiscovered gems, you may want to expand your criteria to small and mid cap stocks.

Based on our insights above and extensive research, we would focus on finding growth stocks that meet these four criteria:

  1. Large companies (for lower-risk growth stocks) OR smaller companies (for higher-risk growth stocks)
  2. Strong and steady sales and earnings growth (NOT necessarily very fast growth)
  3. A history of being profitable
  4. Trading at a “fair price” (not deeply undervalued but definitely not highly overvalued)

Let’s take these criteria and use the FinViz stock screener to find some strong growth stock candidates.

How Do You Find the Best Growth Stocks to Buy? (A Step-By-Step Guide)

Below are the criteria we’d suggest for finding good growth stocks.

Please keep in mind, we’re not suggesting the screening criteria you see below are the absolute perfect criteria. Instead, we think these criteria will give you a VERY strong starting point to refine the parameters to your personal liking and begin your own careful research.

We purposefully left the criteria just a little loose (letting more stocks through) so that you could review the results and tighten the rules where YOU think best.

When we first designed this screen, it reduced an unfiltered list of 7,500 stocks down to just 94 highly attractive candidates.

Keep in mind, your numbers will likely differ from ours in this example because stock data changes every single day.

Here is the screen we’d suggest using to find highly attractive steady growth stocks:

Notice the fields we’ve adjusted are highlighted in yellow. 

Also, you can click here to see the screener and full results in FinViz.

In our results we found large consulting firms such as Accenture (ACN) and Booz Allen Hamilton (BAH), industrial companies such as Boeing (BA) and Republic Services (RSG), retailers such as Best Buy (BBY), Dollar General (DG), CVS Health (CVS), and other well-known names such as Sherwin-Williams (SHW) and Verizon (VZ).

Now, we are not recommending this list as the top growth stocks to go buy right now. Instead, they’re examples of large companies that have managed to steadily grow their sales and earnings and are currently trading at a reasonable valuation.

To find the best growth stocks, you should adjust our parameters based on your own personal goals and investing style. 

Please check the screener HERE to see what stocks make the list today.

Let’s look at how we translated our four major criteria above to our stock screen.

Large companies or smaller companies

This is a personal decision based on your investment goals and strategy. For the purpose of this example, we’ll pick companies that are mid cap ($2B) or larger.

Strong and steady sales and earnings growth

Here we want good, solid, sales growth, but not the best or fastest in the market.

Many investors make the mistake of trying to isolate the companies with the absolute fastest sales growth on the market, thinking they’re the best growth stocks around.

They’re usually disappointed.

Companies with annual sales growth rates of 20%, 30%, 40%, 50%, and beyond don’t tend to make very good investments. They’re often overvalued and rarely continue their incredible growth spurts.

Instead, look for for solid, steady top line growth.

In our stock screener, we selected “Sales growth past 5 years” and filtered for companies in the “Low (0-10%)” category. We’ve also selected “Sales growth qtr over qtr” and filtered companies in the “Low (0-10%)” category.

In addition, we’ve selected a range of past and future earnings per share metrics and filtered for “Positive (>0%).”

This should allow us to focus on companies that are growing their sales at a steady rate while also growing their earnings – a powerful combination. 

A history of being profitable

In order to find companies that are turning a profit, we added three filters requiring positive net profit margin, operating margin, and gross margin.

Trading at a “fair price”

Finally, we filtered our growth stocks to find those that are trading at a fair price.

We want stocks that are not deeply undervalued but definitely not highly overvalued.

Based on our extensive research, “Price / Free Cash Flow” is one of the most powerful valuation metrics for finding companies that are truly undervalued.

According to Investopedia:

“Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets.”

It’s a good measure of how much cash a company is actually generating for its shareholders.

By comparing it to the price of the stock, we’re able to focus on companies that are generating lots of cash relative to how investors have valued the shares and screen out companies generating relatively little cash flow relative to the value of the shares.

We chose a price / free cash flow ratio under 50, but you can adjust that setting to be more or less strict, depending on your strategy.

Lesson Summary (Growth Investing): A Step-by-Step Guide to Picking the Best Growth Stocks

When it comes to finding the best growth stocks, our research suggests steady growth beats high-flying growth.

Here are a few important takeaways from our lesson today:

  • In general, growth stocks are companies that are expected to have unusually high growth in their future sales and/or earnings.
  • Growth stocks shine during bull markets as they’re buoyed by a strong economy and bullish investor sentiment.
  • Growth stocks can also be surprisingly profitable during times of slowing economic growth or even bear markets.
  • A story growth stock is when investors believe the company is going to grow very rapidly over the next 5-10 years and somehow substantially disrupt or take over an industry.
  • Another flavor of growth stock is the steady growth stock, which delivers steady above average sales and earnings growth year after year. They have found a formula for steady profitable growth and can often deliver through good times and bad.
  • Look for companies with steady sales and earnings growth and positive margins that are currently trading at reasonable valuations.
  • Filtering steady growth stocks to see which are currently trading at a fair valuation can help avoid overpaying for growth.
  • Fish among small cap stocks for higher risk / higher reward stock picks and focus on mid and large caps for more steady recognizable names.
  • Adjust the growth stock screen based on your own strategy here.
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Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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