What is a growth stock, and how to choose one

What is a growth stock?

There are several strategies investors can use to make money on the share market. A popular approach is to buy shares in growth stocks. 

A growth stock is a company that is expected to grow its profit and revenue faster than the general market. Companies that can do so for an extended period often see their share prices climb. This rewards investors with returns via capital appreciation. 

It is important to remember that with reward comes risk, so it’s essential to understand the basics of growth stock investing and its risks before starting out on a growth investing strategy. Growth shares can fall more rapidly in a bear market, but with the appropriate strategy, the risks can be minimised. 

So, if you’re looking to get into growth investing, how do you find ASX growth shares to invest in? Here are a few methods we use to identify ASX growth shares with the potential for major gains. 

What is the appeal of ASX growth shares? 

Growth shares appeal to investors because the stock market often values a company on a multiple of its earnings. Therefore, earnings growth is usually accompanied by share price appreciation. The faster the earnings growth, the quicker the appreciation in the stock price. 

Beyond profit and revenue, common traits of successful growth shares include large market opportunities and strong business models. 

How to find growth stocks on the ASX

If you look at today’s high-growth ASX shares, you will note that many did not exist even a decade ago but have since become well-known. WiseTech Global Ltd (ASX: WTC), Altium Limited (ASX: ALU), and TechnologyOne Ltd (ASX: TNE) started out as small players but have steadily increased their markets and customer numbers. This has helped drive huge revenue growth, which has led to massive share price increases.

So, how do you identify the next WiseTech, Altium, or TechnologyOne while it is still in its infancy? One method is to think through your habits and see if you can identify products or services you are using regularly today that you haven’t used in the past. If you (or your friends) have fallen in love with a new product or service, there’s a decent chance the company behind it is worth investigating. 

Examples include: 

• Concerns about climate change and the move toward low-emissions energy sources have benefitted companies in the hydrogen sector, such as Pure Hydrogen Corporation CDI (ASX: PH2)
• The rise of cloud computing, together with more people working from home, has led to increased demand for cybersecurity solutions, benefitting companies such as Tesserent Ltd (ASX: TNT) and Prophecy International Holdings Limited (ASX: PRO)
• Advances in infection control and decontamination have spurred demand for disinfection and sterilisation technology from Nanosonics Ltd (ASX: NAN)
• The trend toward purchasing online has led to increased revenue for online retailers such as Temple & Webster Group Ltd (ASX: TPW).

Think about your spending and determine if you can recognise any patterns. Are there stores that you didn’t purchase from previously but now do? Are there new technologies that you or your workplace are benefitting from? 

A simple internet search can help you find the companies behind the products and services you love. If the company is listed on the ASX and still in the early stages of growth, you may have stumbled upon a potential winner. 

Keep an eye out for macro societal trends

The best growth shares tend to benefit from massive changes that ripple through society. Companies that can capitalise on trends that take time to play out will often see revenue and profit growth for years and can generate significant returns for investors. 

So, what macro trends are happening now that investors can take advantage of? Here are a few we are following with great interest: 

Remote working

The coronavirus pandemic triggered a huge change in the workplace, with millions of people working from home for months. Many office workers found they valued the lack of commute and flexibility of working from home. Workers are now allowed to return to their city offices. However, many companies now offer their staff the option of continuing to work from home permanently or a hybrid arrangement with some days at home and some days in the office. 

ASX companies that facilitate remote working are the beneficiaries of this trend. Examples include Whispir Ltd (ASX: WSP), which provides a communications workflow platform that automates interactions, and CV Check Ltd (ASX: CV1), which helps companies bring employees on board.   

Online shopping

Online retailing has grown dramatically in Australia over the past five years. The pandemic has accelerated this rapid growth. Lockdowns closed shops, and consumers opted for the safety of home delivery, leading to a surge in online orders. Retailers with a strong digital presence, such as Kogan.com Ltd (ASX: KGN), Temple & Webster, and Adairs Ltd (ASX: ADH), have seen sales soar as a result.

Digital payment technology

Fewer Australians were paying with cash even before the pandemic. Now, many businesses are actively encouraging customers to use digital payment methods. Increased online shopping has also seen the use of digital payment methods rise. Companies that are leveraged to this trend include payment systems provider Tyro Payments Ltd (ASX: TYR) and buy now, pay later (BNPL) providers such as Zip Co Ltd (ASX: ZIP).

The rise of online advertising

Investment in digital advertising continues to grow as consumers spend more time online. During worldwide lockdowns, consumers weren’t exposed to outdoor advertising. They are also increasingly rejecting paper-based advertising. 

As a result, advertising spending is increasingly shifting to online channels. According to Statista, digital ad spending in Australia will reach US$7.526 million this year, which equates to US$370.34 per internet user. This creates huge opportunities for companies that can reach customers online, such as digital advertisers REA Group Limited (ASX: REA) and Carsales.Com Ltd (ASX: CAR).

These are just a few of the macro shifts taking place in society. Next time you notice one happening, do some research to see if there are any ASX-listed companies set to benefit from the trend. 

Piggyback on the legends

Fund managers usually have huge research budgets that they use to find great businesses. They also issue quarterly and even monthly reports on their holdings. You can take the opportunity to look through their recent buys and sells to see which ASX shares they favour. 

While not every fund manager is worth following, there are several that can be a great source of investing ideas. A couple of our favourite growth investors are: 

• Josh Clark of QVG Capital: Clark started out as a quantitative analyst, and his long-short fund was crowned the No. 1 Australian equities strategy in 2020, according to a survey on investment manager performance
• Mark Arnold of Hyperion Asset Management: Arnold has a philosophy of investing in high-quality growth businesses over the long term. This has paid off, with the Hyperion Australian Growth Fund delivering returns of 10.7% per annum over the past five years.  

There are a number of websites that track the performance of Australian fund managers, including Investsmart¹ and Canstar². Growth investors can visit these sites for updated performance metrics on Australian managed funds.

Looking into the recent buys and sells of top-performing funds can provide some quality ASX share ideas for individual investors.

How to use stock screening tools

Another reliable source for unearthing promising ASX growth shares is free stock screening tools. These tools allow investors to sort ASX shares by certain parameters, which can help identify growth shares. 

For example, Investing.com allows users to sort ASX shares by yield, price-to-earnings (P/E) ratio , profit margins, and sales, among other variables.³ Here are a few parameters that can be used to screen the market for growth shares: 

Market capitalisation: This metric is a quick way to measure a company’s size. If investors discount small-cap shares, they can use this metric to screen them out. You can also use this metric to identify large-cap shares in your area of interest. As a rough guide, shares with a market cap of more than $100 million will generally appear in the ASX 300.

Profitability: Companies that consistently generate profits tend to be less risky than those burning through capital. For this reason, many investors favour growth shares that have already crossed over into the black. A quick way to screen for profitability is to set the P/E ratio to a positive number. This will screen out any ASX shares that have not yet produced positive net income.

Sales growth: The best growth shares are companies capable of growing profits for years to come. To do this, they need to be able to increase revenue and sales reliably.

Projected profit growth: ASX analysts are paid handsomely for following companies closely and publishing reports that predict their growth rates over the next several years. Although these predictions can be inaccurate, they are helpful in gauging what the market expects from particular companies.

Sector: Some sectors are harder for investors to make money in than others. For example, some prefer to avoid commodity industries in favour of sectors where companies can build a lasting competitive advantage.

Technology, healthcare, services, and financial sectors can provide fertile fishing grounds. Nonetheless, it is important that investors understand the industry they are investing in. Make sure you do your research and have a decent level of knowledge about how your preferred sectors operate.

Balance sheet: While debt isn’t always a bad thing, some investors prefer to avoid companies carrying large amounts of debt on their balance sheets. You can use the debt-to-equity ratio to eliminate highly-indebted companies. 

This ratio compares a company’s total debt to its shareholder equity. A good rule of thumb is to set the debt-to-equity ratio below 30%. Obviously, the lower this number, the less debt. While you may prefer to be conservative when it comes to debt, keep in mind that some industries naturally use more debt than others, so be careful when comparing ratios across industries. 

A search example…

With these parameters in mind, let’s run an ASX share search using the following criteria: 

• Market cap above $100 million
• Profitable with a positive P/E ratio 
• Positive five-year sales growth
• Positive revenue 
• Earnings per share (EPS) growth over five years  
• A debt-to-equity ratio below 0.3. 

As at August 2022, Investing.com identified 23 companies matching these criteria. Here’s a look at the top 10 by market cap: 

While there is no bulletproof formula for creating a list of great ASX growth shares, using screening tools can be a great way of identifying potential winners. It can also be a good way of discovering growth companies while they are still small. When companies are in the early stages of their growth cycle, investors can get in on the ground floor. 

Discover the next big thing

Altium is one example of a dynamic growth share you can discover using screening tools like Investing.com. Altium’s revenue increased 23% in FY22 while profit increased 57%, despite the lingering effects of the pandemic.

So, what does Altium do? The company provides software used to design printed circuit boards (PCBs). PCBs are used in the vast majority of electronic devices. With the rise of the internet of things (IoT), more and more devices are interconnected and hence require the design of PCBs. Altium plans to transform the PCB industry by achieving market dominance. 

Altium’s monthly active users has grown steadily throughout the pandemic, from fewer than than 5,000 in Q4 FY20 to nearly 25,000 in Q4 FY22. Annual recurring revenue (ARR) has also grown steadily, from US$90.2 million in FY20 to US$123.5 million in FY22. Total revenue for FY22 was US$220.8 million. By FY26, Altium aims to achieve annual revenue of US$500 million.  

Altium’s annual recurring revenue: 

Total annual revenue for FY23 is predicted to be between US$255 million and US$265 million. 

Altium is also benefitting from increasing earnings before interest, tax, depreciation, and amortisation (EBITDA) margin, which was up 2.9% to 36.2% in FY22, and is predicted to reach 28% to 40% by FY26. The expanding margin is being driven by operating leverage and a higher proportion of recurring revenue. This has, in turn, boosted profit, which was up 57% in FY22 to US$55.5 million. One of the benefits associated with Altium is that the company has already grown big enough to generate a meaningful profit and cash flow, which helps lower its risk profile. 

The pandemic has been a catalyst for Altium’s pursuit of market dominance and transformation. The company’s cloud platform, Altium 365, is increasing the attractiveness of its design software, resulting in greater demand and competitive advantage. Its Altium Designer program is gaining adoption, resulting in higher revenue per seat.  

Altium is well-positioned to disrupt the way electronic products are designed and manufactured. The company has the ability to simultaneously bring data, processes, and commercial transactions together on a singular cloud-based digital platform at a large scale. It is on track to achieve mainstream dominance with a diversity of applications and high-profile customers, including Tesla Inc (NASDAQ: TSLA), Boeing Co (NYSE: BA), Google, and Microsoft Corporation (NASDAQ: MSFT).  

The risks of investing in ASX growth shares 

While investing in growth shares can be great, there is a catch-22 that investors should be aware of. When the market believes a company will rapidly increase its profit, it is usually rewarded with a high valuation. This greatly increases the risk that the share price could fall dramatically if it fails to meet expectations. That’s one reason why investors should know the fundamentals of growth stocks and do their homework before diving in. 

Let’s circle back to Altium to see this in effect. As at the time of writing, Altium is trading at more than 60 times earnings and has a dividend yield of just 1.3%. These numbers are high and low, respectively, when compared to the S&P/ASX 200 Index (ASX: XJO) market average. This raises the risk profile of Altium significantly. If the company fails to deliver on investor growth targets, the share price could fall significantly.

Another risk investors need to be mindful of is that growth shares are usually much more susceptible to wild price swings in turbulent markets than value shares. Volatility can be unnerving at times, so if you can’t handle big price swings, growth investing might not be for you. Altium, for example, fell from a high of more than $45 in late 2021 to just $25 in June 2022, although it has since recovered to about $35 in October 2022. 

Is growth investing right for you?

Using these methods will help you uncover dozens of shares that hold growth potential. Of course, finding growth shares is one thing. Having the conviction to buy them and then hang on through thick and thin is another.

If you can learn to do so successfully, however, you’ll put the power of compounding on your side and be in a great position to generate meaningful wealth over the long term.