The Motley Fool

How to Choose and Invest in Growth Stocks

Stocks going to the moon

Published and Updated March 23, 2021 by The Motley Fool Staff

With the recent success of Canada’s own Shopify, growth investing is fresh on most Canadian investors’ minds. No doubt investing in growth stocks can catapult your investment portfolio, but how do you even get started? And what are some of Canada’s most promising growth stock companies? Let’s look closer at growth stocks and find out. 

What Are Growth Stocks? 

Growth stocks are stocks of companies that are growing their revenue at a faster rate than the average of their sector – and these companies are usually willing to sacrifice profitability to grow as quickly as possible.

When you invest in growth stock companies you’re not investing in a company with a long, successful past: you’re investing in a company with a long, promising future. For that reason, growth stock companies share some common characteristics.

Here are five things you should know about them. 

1. They have a competitive advantage

 

Growth stocks companies typically have an innovative product or service that no other business provides, or, if they do provide, not as well. They could boast new technology that no one else has, or patents to product lines no one has seen before. 

2. They have a loyal consumer base

 

Because of their unique products or services, growth stock companies usually win the masses over, driving stock values (and expectations) up. 

3. They typically don’t pay dividends

 

In order to accelerate their expansion in their industries, growth stock companies reinvest profits – if any- in themselves, rather than paying out dividends. For investors, that often means you won’t make much in the short-term. But if the company is as promising as it seems, you can make extraordinary capital gains over the long-term. 

4. They look expensive

 

Growth stocks usually have higher prices relative to the company’s earnings (or a high P/E ratio). That’s because investors are expecting higher earnings over the long-run, regardless of what they’re earning now. They may look expensive today, but three, five, even ten years from now, these prices will look unbelievably low.

5. Their market prices are more volatile

 

Growth stock prices are hypersensitive to change. When the company does better than expected, prices soar; when they disappoint, stock prices drop hard. Likewise, during a bear market, when the overall value of stocks declines, growth stocks tend to take the hardest hit, as investors become increasingly uncertain about the company’s future. 

How Are Growth Stocks and Value Stocks Different? 

Value stocks are stocks that are trading below the price most analysts believe the stock is worth. In essence, they’re unadvertised bargains: you buy a share for a low price in the hopes that the company will rebound, rewarding you handsomely. 

While growth stock companies are usually new startups, value stock companies are typically older, more well-established companies that have slowed down in recent years. Value stock investors see these companies as hidden gems: they believe their stocks are undervalued, and, with time, they’ll bounce back. 

Though often pitted against each, growth stocks and value stocks both share a common strategy: buy low and sell high. One difference, however, is that value stocks often involve less risk. Because value stock companies are well-established, you’ll likely see some gains, even if they’re not exponential. 

But market risk shouldn’t deter you from investing in growth stocks. If you have good reason to believe a company is on the verge of breaking out, by all means—invest in it. The returns you get on certain growth stocks could far exceed those gained through value stocks. 

How to Choose Growth Stocks in Canada

Growth stocks aren’t always easy to spot. Sometimes they’re growing quietly behind the scenes, just one innovation away from taking off. Other times they’ve gained a large following, but they’re so new, you’re unsure of their future success. While no one can predict the next Shopify or Amazon, here are a few things to look for. 

1. Pay attention to cultural trends

Growth stock companies often ride the waves of societal changes and megatrends. Trader Joe’s and Whole Foods, for instance, wouldn’t have grown without the environmental and organic food movements. Amazon and Shopify wouldn’t have developed without a growing desire for better e-commerce experiences. And Netflix wouldn’t have gone anywhere if people hadn’t been frustrated with Blockbuster’s late fees and high cable prices. 

You may find it difficult to stay on top of emerging trends, but here’s the thing—usually, you’re a part of the trend. Often you’ll find new growth companies not through the news or other investors but by looking at your consumer habits and noticing new patterns. 

If a new product or service has changed the way you traditionally do something—buying groceries, banking, or even communicating with colleagues in a work-from-home situation—the company behind them is worth looking into. 

2. Identify companies with strong competitive advantages

Companies that grow fast have products or services that few businesses can match. Some competitive advantages to look for:

  • Network effects: The network effect happens when the value of a product or service improves as more and more people use it. Think of Slack. If two people in a company of 1,000 use Slack, its value diminishes. But if 898 people are using it, you better believe the remaining 102 won’t be far behind.
  • High switching costs: Switching costs are what consumers pay—in dollars, time, and effort—to switch from one supplier to another. Take Shopify, for instance. Once a business starts using Shopify for its online operations, it becomes a major hassle to switch to one of Shopify’s competitors.
  • Low-cost producers: Low-cost producers take items that consumers are unlikely to cut out—like bread or toothpaste—and produce them at a lower cost than similar companies. They might have a better way of making an item, or they produce the item at such a large scale, they can afford to sell them at lower prices. Walmart and Aldi are good examples of low-cost producers.

3. Look for niche markets

The best growth stock companies emerge in uncharted markets where they have ample room to grow. Over time these companies dominate their niche, until they emerge into the broader market. 

If you notice a company that sells one product or service so well that they have a loyal customer base, take notice—you may have found your growth stock company. 

What are some of the best Canadian growth stocks? 

In recent years, Canada has seen the rise of several growth stock companies. Here are just four to keep your eye on.

1. Shopify 

With more than a 1,000,000 merchants in its user base, a number that’s sure to leap in the coming years, Shopify (TSX:SHOP)has established a solid presence in the e-commerce market. During the pandemic, when lockdowns prevented customers from shopping in brick-and-mortar stores, Shopify’s revenue soared, as businesses continued to turn to Shopify’s easy-to-use platform. Given that e-commerce remains a major global trend, investors with Shopify shares will most likely be very happy for years to come.

 

2. Docebo 

Another pandemic favorite, Docebo (TSX:DCBO) helps companies train employees from a distance. Docebo’s client base is growing quickly—Amazon and Walmart are two of its biggest customers—and though its stock took a hit at the start of the year, it’s still a strong company with a loyal fan base that’s poised to grow even more.

 

3. Lightspeed POS

Lightspeed POS (TSX:LSPD) is a point-of-sale and e-commerce provider who’s seen immense growth over the last few quarters. Unlike Shopify, Lightspeed does most of its business in brick and mortar stores, which was why the company took a big hit at the start of the pandemic. Since last March, however, Lightspeed has grown over 600% in 11 months, and with big plans to expand globally, this company is set to soar higher.

 

4. Dye & Durham 

Dye & Durham (TSX:DND) business professionals get access to public records and government registry data. It might not sound exciting, but in recent years Dye & Durham has built an impressively large customer base, due in part to the 19 acquisitions its made since 2013. Riding on a strong demand for its products and services, Dye & Durham is definitely a company you want in your stock portfolio. 

Should You Invest in Growth Stocks? 

Growth stocks can help you take advantage of a company’s rapid expansion and higher-than-average revenues, but whether or not you should invest in them comes down to your investment goals and level of risk. 

If you’re okay waiting for a growth stock company to reach its full potential, if you’re comfortable with growth stock being sensitive to price swings, then growth stock investing might be right for you. 

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