Growth investing

Investors have a range of strategies at their disposal to make money on the share market. One popular approach is to buy shares in growth stocks. 

A growth stock is a business that analysts and investors anticipate will grow profit and revenue faster than the general market. Companies that can do so for an extended period often see their share prices climb quickly. 

This rewards investors with significant returns via capital appreciation. 

The appeal of growth

Growth shares are an attractive investment because the stock market tends to value a company on a multiple of its earnings. Therefore, earnings growth typically prompts share price appreciation. The faster the earnings growth, the quicker the increase in stock price. 

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

However, it is essential to remember that with great reward comes risk, so understanding the basics of growth stock investing and its risks is critical before starting a growth investing strategy. 

In a bear market, growth shares can fall more rapidly, but investors can minimise risk with an appropriate strategy. 

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 to identify stocks with the potential for significant gains. 

Where to look for growth shares

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 Xero Limited (ASX: XRO) started out as small players but have steadily increased their markets and customer numbers. 

This has helped drive tremendous revenue growth, which in turn has led to massive share price increases.

So, how do you identify the next WiseTech, Altium, or Xero while it is still in its infancy? One way is to think through your habits and see if you can identify products or services you are using regularly today that you didn't use 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 towards low-emissions energy sources have benefitted companies in the renewable energy sector, such as Meridian Energy Ltd (ASX: MEZ)
• The rise of cloud computing, together with more people working from home, has led to increased demand for connectivity and cybersecurity solutions, benefitting companies such as Data#3 Ltd (ASX: DTL) and Prophecy International Holdings Limited (ASX: PRO)
• The trend toward purchasing online has led to increased revenue for e-commerce retailers such as Temple & Webster Group Ltd (ASX: TPW) and Kogan.com Ltd (ASX: KGN).

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 able to capitalise on trends that take time to play out will often see revenue and profit growth for years. This 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: 

Artificial Intelligence: The proliferation of artificial intelligence is having a transformative effect on society. The combination of machine learning and data analytics offers unprecedented insights and automation, revolutionising sectors from healthcare to finance. As AI technologies evolve, they create growth opportunities for businesses that harness their potential. 

Investors are closely watching ASX companies at the forefront of the AI revolution, such as Brainchip Holdings Ltd (ASX: BRN), which develops AI and machine learning hardware. Another is Archer Materials Ltd (ASX: AXE), which develops advanced semiconductor devices and processor chips related to quantum computing and medical diagnostics.

Remote working: The coronavirus pandemic triggered a massive workplace change, with millions working from home for months. Many office workers valued the lack of commute and flexibility of working from home. Workers are now able to return to their city offices. However, many companies offer their staff the option of working 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 Megaport Ltd (ASX: MP1), which enables connectivity between data centres and cloud environments.   

Online shopping: Online retailing has grown dramatically in Australia over the past five years. The COVID-19 pandemic 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 solid digital presence, such as Kogan, Temple & Webster, and Adairs Ltd (ASX: ADH), saw sales soar during the initial stages of the pandemic.

Digital payment technology: Fewer Australians paid 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 leveraged this trend include payment systems provider Tyro Payments Ltd (ASX: TYR), digital payments and banking company Novatti Group Ltd (ASX: NOV), 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 thanks to the ever-expanding online presence of consumers. Global lockdowns confined consumers to digital screens, making outdoor advertising largely ineffective. Furthermore, there's a growing trend of consumers shunning traditional paper-based advertisements. 

As a result, advertising spending is increasingly shifting to online channels. According to Statista, digital ad spending in Australia will reach US$12.56 billion in 2023.¹ 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, research to see if any ASX-listed companies are likely to benefit from the trend. 

Piggyback on the legends

Fund managers usually have substantial 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 the holdings of successfully managed funds and 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. These include: 

• Hyperion Australian Growth Companies Fund aims for long-term capital growth by investing in high-calibre Australian companies primarily listed within the S&P/ASX 300 Index. 
• Prime Value Australian Equities Emerging Opportunities Fund invests in listed companies outside the 100 largest on the Australian stock market. This provides an extensive range of quality companies and less competition from other investors. 
• DNR Capital Australian Emerging Companies offers exposure to a concentrated portfolio of high-quality, small-cap Australian listed equities.  

Several websites track the performance of Australian fund managers, including Investsmart² and Canstar³. 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.

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 specific parameters, which can help identify growth shares. 

For example, Investing.com⁴ enables users to sort ASX shares by yield, price-to-earnings (P/E) ratio, profit margins, and sales, among other variables. Here are a few parameters that you can use to screen the market for growth shares: 

Market capitalisation: This metric is a quick way to measure a company's size. If investors dislike small-cap shares, for example, they can use market cap 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 positive. 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 do this, they need 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 help gauge what the market expects from particular companies.

Sector: Some sectors are more challenging 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, investors must 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 bad, 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 regarding debt, remember that some industries naturally use more debt than others, so be careful when comparing ratios across industries. 

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 of October 2023, Investing.com identified eight companies matching this criteria. Here's a look at the eight organised by market cap: 

While there is no bulletproof formula for creating a list of outstanding 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 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 19.2% in FY23, while profit increased 19.6%.

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

Altium's monthly active users have grown steadily in recent years, from fewer than 5,000 in Q4 FY20 to more than 36,000 in Q4 FY23. 

Annual recurring revenue (ARR) has also grown steadily, from US$90.2 million in FY20 to US$202.5 million in FY23. Total revenue for FY23 was US$263.3 million. By FY26, Altium aims to achieve an annual revenue of US$500 million.  

Altium's annual recurring revenue: 

Total annual revenue for FY24 is predicted to be between US$315 million and US$325 million. 

Altium also benefits from increasing earnings before interest, tax, depreciation, and amortisation (EBITDA) margin, which was 36.2% in FY23 and may reach up to 37% by FY24. The expanding margin is driven by operating leverage and a higher proportion of recurring revenue. 

This has boosted profit, with net profit after tax (NPAT) up 19.6% in FY23 to US$66.3 million. One of the benefits associated with Altium is that the company has already grown big enough to generate 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, generating higher revenue per seat.  

Altium is well-positioned to disrupt the way electronic products are designed and manufactured. The company can 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 rewarding, there is a catch-22 that investors should be aware of. When the market believes a company will increase its profit rapidly, it usually rewards the business with a high valuation. 

This significantly increases the risk that the share price could dramatically fall 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 55 times earnings and has a dividend yield of just 1.24%. These numbers are high and low, respectively, compared to the S&P/ASX 200 Index (ASX: XJO) market average. This raises the risk profile of Altium. The share price could fall significantly if the company fails to meet investor growth targets.

Another risk investors must consider is that growth shares are usually much more susceptible to wild price swings in turbulent markets than value or dividend shares. Market volatility can be unnerving, so growth investing might not be for you if you can't handle big price swings. 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 around $44 in November 2023. 

Is growth investing right for you?

These methods will help you uncover dozens of shares with 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.

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