Growth investing is one of the most popular styles out there, and here we'll take a comprehensive look at the steps involved in taking advantage of this strategy.

What is growth investing?

Growth stocks tend to hold promising positions in emerging industry niches that feature long runways for expansion ahead of them. Because of this desirable potential, and the unusually strong success the business has had in recent years, a growth stock is priced at a premium that reflects the optimism investors have in the company. As a result, the simplest way to know whether you're looking at a growth stock is if its valuation, traditionally its price-to-earnings multiple, is high relative to the broader market and its industry peers.

This approach contrasts with value investing, which focuses on stocks that have fallen out of favor on Wall Street. These are stocks with lower valuations that reflect more modest sales and profit prospects. Both investment strategies can work if applied consistently, but investors usually gravitate toward one side of the spectrum or the other.

Step 1: Prepare your finances

A good rule of thumb is that you shouldn't buy stocks with cash you believe you'll need in the next five years at least. That's because while the market generally rises over the long term, it frequently posts sharp drops of 10%, 20%, or more that occur without warning. One of the biggest mistakes you can make as an investor is putting yourself in a position to be forced to sell stocks during one of these down periods. Ideally, you'll instead be ready to buy stocks when most others are selling.

Step 2: Get comfortable with growth approaches

For example, you can focus only on large, well-established businesses that already have a history of generating positive earnings. Your approach could be anchored in quantitative metrics that fit in stock screeners, such as operating margin, return on invested capital, and compound annual growth. On the other hand, many growth investors aim to purchase the best-performing businesses around, as evidenced by their consistent market share gains, with less of a focus on share prices. 

It often makes sense to focus your purchases in industries and companies you know particularly well. Whether that's because you have experience in, say, the restaurant industry, or in working for a cloud software services business, that knowledge will help you evaluate investments as potential buy candidates. It's usually preferable to know a lot about a small segment of companies than it is to understand just a bit about a wide range of businesses.

For example, T. Rowe Price is credited as being the father of growth investing, and, even though he retired from the field in 1971, his influence is still being felt today. Price helped popularize the idea that a company's earnings growth could be projected out over many years, which shifted investors' thinking at a time when stocks were considered cyclical, short-term investments.

Step 3: Stock selection

Now it's time to prepare to begin making investments. This part of the process starts with deciding just how much cash you want to allocate toward your growth investment strategy. If you're brand-new to the approach, it might make sense to start small with, say, 10% of your portfolio funds. As you get more comfortable with the volatility, and as you build up experience investing through different types of markets (rallies, slumps, and everything in between), this ratio can rise.

Risk plays a big role in this choice, too, since growth stocks are considered more aggressive, and thus, more volatile, than defensive stocks. That's why a longer time horizon generally allows more flexibility to tilt your portfolio toward this investing style.

Buying growth funds

The easiest way to gain exposure to a diverse range of growth stocks is through a fund. Many retirement plans feature growth focused options, and these could form the basis of your investing strategy.

Stepping further out into self-directed choices, consider purchasing a growth-based index fund. Index funds are ideal investment vehicles because they deliver diversification at lower expenses than with mutual funds. That's because, unlike mutual funds, which are run by investment managers who try to beat the market, index funds use computer algorithms to simply match the return of the industry benchmark. Since most investment managers fall short of that benchmark, you'll usually end up ahead of the game with an index fund.  

Screening for growth stocks

• Above-average growth in earnings per share, or the profits the company generates each year.
• Above-average profitability (operating margin or gross margin), or the percentage of sales a company turns into profits.
• High historical growth in revenue or sales. 
• High return on invested capital, which is a measure of how efficiently a company spends its cash.

• The company booked an annual net loss in the past three years. This isn't a deal-breaker for most growth investors, but it does suggest a company has yet to build a sustainable business model.
• The company carries a low market capitalization (of, for example, below $500 million). Tiny stocks are vulnerable to bigger competitors and many other disruptions that could threaten their entire businesses. As a result, many investors feel comfortable beginning their search in the "mid-cap" range of stocks.
• There was a recent management shakeup, particularly in the CEO position.
• Sales and/or profitability is falling. It won't qualify as a growth stock if its core operating metrics are headed lower.
  

Step 4: Maximize returns

1. If a portion of your holdings has gained so much value that it dominates your portfolio, it might make sense to reduce your exposure by rebalancing your portfolio.
2. If a stock rises far above your estimate of its value, you can consider selling it, especially if you've identified other, more reasonably priced investments to direct the funds toward.
3. If the company has hit a rough patch that has broken your original investment thesis, or the reason you bought the stock in the first place, you might want to sell. A broken thesis might include major missteps by the management team, a long-term decline in pricing power, or disruption by a lower-priced competitor.

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