To profit from growth stocks, you need to pick stocks with clear growth prospects and not simply momentum stocks, including many of today’s AI stocks, with uncertain futures

By definition, growth stocks are companies that have above-average growth prospects and often trade at a high p/e ratio. They are firms whose earnings growth has been above the market average, and is likely to remain above average. It is often the case that they pay small dividends or none at all. Instead, they re-invest their cash flow in the business, to promote their growth.

Although these stocks can be highly volatile and typically maintain a high p/e ratio, they often 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, for years or decades.

Understanding two fundamental factors will help you select the growth stocks with the best prospects—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 stocks with momentum stocks. Like growth stocks, momentum stocks, including many of the “AI stocks” now out there, 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 and trends like AI stocks. 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 (including 2024’s hot stock group–AI stocks) all at once, despite their high p/e ratio, and the gains that follow are something of a self-fulfilling prophecy.

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The trouble is that when the stock’s rise wanes, momentum investors also try to get out as a group. But there are never enough buyers to accommodate them. That leads to violent fluctuations in the stock’s price.

2. Value stocks can lower your portfolio’s volatility: Most successful investors will hold some growth stocks 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.

   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.

If you invest as we advise—by spreading your investments across the five main economic sectors, investing mainly in well-established companies with reasonable valuations rather than those with an extremely high p/e ratio, and staying away from stocks in the broker/media limelight—you will automatically own some growth stocks and some value stocks.

That helps you achieve good results while decreasing volatility. In the end, however, the relative amounts that you invest in growth stocks versus value stocks are less important than your portfolio’s diversification and overall investment quality.

In summary, this article explores the fundamental differences between growth stocks and value stocks, offering crucial insights for investment strategy. Growth stocks, characterized by above-average growth prospects and often commanding premium valuations, are contrasted with momentum stocks, which can experience volatile price movements due to short-term trading patterns. The article emphasizes the importance of understanding that while growth stocks may have higher valuations, they offer long-term investment potential through sustained earnings growth and business reinvestment. A key distinction is made between genuine growth stocks and momentum stocks, particularly in the context of current market trends like AI stocks. The piece advocates for a balanced investment approach, suggesting that a mix of both growth and value stocks can optimize portfolio performance while managing risk. It concludes by recommending sector diversification and focusing on well-established companies rather than those garnering excessive media attention, highlighting how this strategy naturally leads to a balanced portfolio of both growth and value investments.

COMMENTS PLEASE—Share your investment experience and opinions with fellow TSINetwork.ca members.

When you buy a growth stock, do you plan to keep it for the long term as it grows bigger, or are you simply looking at taking profits after the stock has a growth spurt? Are you willing to hold stocks like these when the share price takes a dip, as many supposed AI stocks are likely to? Let us know what you think.

This article was originally published in 2012 and is regularly updated.