Investing in growth stocks is a well-traveled path to unlocking life-changing wealth from the stock market. That’s because most of the biggest winners of our lifetime come from the growth camp. Especially those growth companies with life changing innovations.
Think about how smartphones came on the scene and Apple (AAPL) went from losing the PC wars to a thriving company creating trillions in shareholder value. That is one of many such growth stock success stories.
However, the harsh reality is that most growth investors failed to take advantage of these opportunities. They failed because they too often pick the wrong stocks.
We are about to change all that. Because in today’s article, I want to discuss 3 strategies to help investors pick better growth stocks in the future:
- Pay Attention to Total Addressable Market (TAM)
- Buy the Leaders
- Look for Operating Leverage
Pay Attention to Total Addressable Market (TAM)
One of the common traits in the most successful growth stocks is that the market failed to grasp the ultimate Total Addressable Market (TAM) of a product. Let’s go back to our smartphone example. It was initially thought of as a luxury item that was only appropriate for wealthy people or technophiles. Now, it’s essentially a necessity, and more than a billion are sold every year.
We see the same dynamic with social media. A decade and a half ago, it was hard to imagine that social media would be ubiquitous and become the primary form of entertainment for younger demographics. Very few could have anticipated its impact on politics or culture or that companies like Facebook (FB) would have more than 3 billion users across all of its platforms.
Growth stocks are priced based on their potential. So a big opportunity for investors is to find stocks where the market is underestimating the TAM. A bigger TAM means more upside potential for the stock.
Now, let’s look at TAM from the other perspective. During the pandemic and shutdowns the special situation winners were stocks like Zoom (ZM) and Peleton (PTON) because their TAM exploded higher in an instant. Those who appreciated this concept at the earliest possible stages enjoyed phenomenal rewards.
Buy the Leaders
Another strategy to pick better growth stocks is to focus on the leading companies in a sector. Famed investors like Peter Lynch and Jim Cramer are the biggest advocates of this concept.
Think about it like this; It’s a winner-take-all-world.
That’s true whether it’s Tom Brady appearing in 10 of the last 20 Super Bowls, Lebron James in 9 out of the last 11 NBA Finals, or the early market share leading dominating its industry (and the stock market). .
It sounds simple but it’s not necessarily easy. Within a certain growth category, there will be stocks that look cheaper than the leading stocks. This will make them very tempting because they will also likely have underperformed which tricks many investors into thinking they’ve uncovered a bargain. Yet it won’t necessarily untap the largest gains.
Going back to our social media example, we can see the scale of this mistake. Since their IPOs, Facebook is up more than 700%, while Twitter (TWTR) is up 8%. Facebook managed to capture the vast majority of shareholder value that was created during the social media boom while leaving some crumbs for its competitors.
An example from the previous bull market is e-commerce. Imagine someone correctly anticipating that e-commerce would take an increasing share of total consumer spending, but they tried to get clever by buying a smaller e-commerce company like Overstock (OSTK) rather than Amazon (AMZN).
It would be very sad story - similar to buying Twitter instead of Facebook. Over the last 2 decades, Amazon is up more than 50,000%. In contrast, Overstock has actually underperformed the Nasdaq.
All the above should make it clear why its important to be on board the market leaders.
Look for Operating Leverage
The final strategy to selecting the best growth stocks is by looking for companies that have operating leverage. This means that as the company grows in size, margins increase as per-unit costs decline.
This combination of increasing revenues and expanding margins can be explosive for earnings growth and share prices over time. You can find stocks with operating leverage by looking for companies with a high proportion of fixed costs to variable costs.
‘Platform as a Service’ (PaaS) cloud computing stocks are a great example of this. Most of these companies’ costs come from building the software and then marketing for user growth. The extra cost of new users joining the platform is minimal. This means that there is significant capacity for earnings growth, once the business becomes cash-flow positive.
Network effects are another form of operating leverage and are particularly important for tech investors to understand. Networks with more users are inherently more valuable and useful which in turn can attract more users, creating a positive, feedback loop.
Thus, growth investors should look to identify companies with operating leverage as they have the biggest potential in terms of earnings growth and the business becoming more resilient.
What to Do Next?
Apply these lessons now to find the big winners of the future. A great example of that is tapping into one of the hottest growth trends in the Metaverse.
Heck, Facebook thinks this is such a big deal that they are actually changing their name to Meta (not like Facebook wasn’t already a household name).
You can learn about the tremendous growth opportunities of the Metaverse in our new special report that we are making available to folks who start a 30 day trial to our POWR Growth newsletter.
And you really should consider that starting that trial since this growth stock service harnesses a proprietary strategy with average annual returns of +46.42% a year. (Even more impressive is how well it does during bear markets).
Interested? Then click below to learn more:
30 Day Trial to POWR Growth + Metaverse Special Report
SPY shares . Year-to-date, SPY has gained 26.87%, versus a % rise in the benchmark S&P 500 index during the same period.
About the Author: Jaimini Desai
Jaimini Desai has been a financial writer and reporter for nearly a decade. His goal is to help readers identify risks and opportunities in the markets. He is the Chief Growth Strategist for StockNews.com and the editor of the POWR Growth and POWR Stocks Under $10 newsletters. Learn more about Jaimini’s background, along with links to his most recent articles.
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