There are two fundamental things you should know about making growth stock picks.
Growth stocks are companies whose earnings growth has been above the market average, and is likely to remain above average. As well, most often, these firms pay small dividends or none at all. Instead, they invest their cash flow into promoting their growth.
Although these growth stock picks can be highly volatile, they can make good long-term investments. They may be well-known stars or quiet gems, but they do share one common attribute—they are growing at a higher-than-average rate within their industry, or within the market as a whole, and could keep growing for years or decades.
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Here are two fundamental factors that will help you make winning growth stock picks—and avoid mistakes that can kill your profits:
1) Know the difference between momentum stocks and growth stocks: It’s very easy to confuse growth stock picks with momentum stocks. Like growth stocks, momentum stocks often move up faster than the market averages. But momentum stocks attract a different kind of investor. Growth-stock investors are in for the long haul, while momentum investors aim to profit from short-term trades. Momentum investors are particularly keen to jump in on a so-called “positive earnings surprise.” That’s when a company outdoes brokers’ earnings estimates.
Momentum investors see a “negative earnings surprise” (or lower-than-expected earnings) as a sell signal. They use a number of formulas to make buy and sell decisions, but all come down to “buy on strength and sell on weakness.” So they tend to pile into the same stocks all at once, and the gains that follow are something of a self-fulfilling prophecy.
The trouble is that when the stock’s rise falters, momentum investors also try to get out as a group. The trouble is, there are never enough buyers to accommodate them. That leads to violent fluctuations in the stock’s price.
2) Add Value stocks as well to lower your portfolio’s volatility: Most successful investors hold some growth stock picks and some value stocks at any given time, depending on where they discover the best opportunities.
Value stocks are stocks trading lower than their fundamentals suggest. They are perceived as undervalued, and have the potential to rise. Many technology stocks, for instance, start out as growth stocks and transition into value stocks. One company that appears to be making the transition, for example, is security and anti-virus specialist Symantec, symbol SYMC on Nasdaq (a stock we analyze in our Stock Pickers Digest newsletter).
Together, growth stocks and value stocks can form a winning combination. A growth stock can be a top performer while the company is growing. However, a single quarter of bad earnings can send it into a deep, though often temporary, slide. Value stocks can test your patience by moving sluggishly for months, if not years. But they can make up for it by rising sharply when investors discover their true value.
Our advice: If you invest as we recommend—by spreading your investments out across the five main economic sectors, investing mainly in well-established companies and staying away from stocks in the broker/media limelight—you will automatically have some growth stocks and some value stocks.
That helps you achieve good results while reducing volatility. But in the end, we think the relative amounts you invest in growth and value stocks should be secondary to your portfolio’s diversification and overall investment quality.
What are growth stocks?
By definition, growth stocks are companies that have above-average growth prospects. They are firms whose earnings growth has been above the market average, and is likely to remain above average. As well, most often, these firms pay small dividends or none at all. Instead, they invest their cash flow into promoting their growth.
Although these stocks can be highly volatile, they often make good long-term investments. They may be well-known stars or quiet gems, but they do share one common attribute—they have grown at higher-than-average rates within their industries, or within the market as a whole, and could keep growing for years or decades.
Have you had success in the past with growth stock picks? Share your experience with us in the comments.
Note: This article was originally published in 2011 and has been updated.