As you build your investment portfolio, it is easy to become attracted to showy stocks that have high return on equity (ROE) potential.  Also known as “glamour stocks,” growth stocks significantly outperform the market and industry earning averages.  To be categorized as a growth stock, the equity must have an anticipated ROE of at least 15%.   

The risks of growth stocks

The truism – the bigger they are, the harder they fall often applies to the stock market.  High flying stocks often have rapid rises and thus have a longer way to fall in pricing if there are sudden turns in the market.  Depending on what level you joined the party; should a crash occur, it could take years for you to recoup your initial investment. 

Investing in growth stocks, like any other financial investment, must be entered with caution. The powerful growth stocks of the last decade, which were the dot com and tech equities such as Yahoo and Juniper, have significantly decreased in popularity since the bubble burst in 2000.  However, the best ROE bargains can still be found in growth stocks and if managed wisely, they can pay off nicely.

Analyzing potential growth stocks

With research and analysis, a good growth stock can be a highly profitable addition to your portfolio.  In finding stable growth stocks with good ROE, there are three factors of analysis that determine its risk-to-reward ratio.  
First, keep an eye on the cash flow of the company.  Look for growth-oriented companies with a history of being able create cash, followed up by investing their earnings back into the companies to spur additional growth.  This provides long-term stability, which will result in sustainable, profitable ROE.

Second, while you are comparing companies, remember to compare apples to apples - not apples to oranges.  You cannot simply compare the price multiples of all stocks, as it varies depending upon the industry and even within an industry.   For example, a PE ratio of 25 may look extremely high when the market averages 17.  However, if you are evaluating a biotech company, the PE ratio of 17 is very low in comparison to the industry average of 35.  It is important to ensure that you are analyzing within the right comparison category. 

Lastly, the greatest catalyst to losing money with growth stocks is greed.  Before you purchase the stock, you should set your selling parameters.  When the stock hits your anticipated ROE, then you should either sell the stock or raise your stop loss level which is the level you will sell immediately to limit your loss or preserve your gain.  One thing that definitely holds true in stock trading is that hope will let you down more often than not. Once a stock hits a skid, you can’t hope it back up. 

The key to successfully investing in growth stocks is to plan and execute a disciplined trading strategy after sufficient research.  Therefore, regardless of how the market, company, or industry turns, you are well protected.

Growth stocks can be a great option for growing your portfolio.  However, it is important to conduct your research and analysis to determine if the high ROE is sustainable and attainable.