3 Things Every High-Growth Investor Needs to Know

By Markets Fool.com

Growth investing can be exciting, and when successful it can be a great way to create wealth over the long run. However, there are some things all growth investors should know before getting started. Here are three:

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Selena Maranjian:It's hard not to want to own shares of companies that post annual revenue growth rates of, say, 30% or more. But it's important to keep it all in perspective.

Successful investing boils down to two things: quality and price. You want high-quality, compelling companies (and rapid growth is compelling), but you also want to buy them at a discount, if possible, or at least for not much more than fair price. Buying growth at any price adds unnecessary risk to your portfolio. Yes, skyrocketing overvalued stocks might keep skyrocketing, but they might also drop closer to their intrinsic value.

Check out the companies below, as an example:

Company 3-year average annual revenue growth 3-year average annual earnings growth Recent P/E ratio 5-year average P/E ratio
Gilead Sciences 41% 55% 13.3 20.2
Baidu.com 50% 24% 16.2 53.8
Constellation Brands 26% 34% 30.7 15.9
Under Armour 28% 27% 84.5 52.3

Data: Motley Fool CAPS, Morningstar.com.

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These companies are all growing briskly, and even have growing earnings. (Many growth stocks will have rapidly growing revenue along with net losses, as the companies use their cash to fuel further growth.) The first two companies, however, sport P/E ratios below their five-year averages, while the second two offer P/Es higher than the five-year average.

A higher than average P/E is not necessarily a deal breaker, but it does warrant a closer look. Is the company's growth rate accelerating, perhaps justifying a higher earnings multiple? Does it have sustainable competitive advantages that can help it keep growing? Are business catalysts on the horizon?

With any portfolio contenders, we'd do well to check out many factors, looking far beyond just growth.

Dan Caplinger: Perhaps the most important element of high-growth investing is developing a strong investment thesis and then having the courage of your convictions throughout good times and bad. Most high-growth stocks go through phases of extreme optimism and extreme pessimism, and if you don't have an independent viewpoint that can survive what can often be a long period of downward share-price movements, then you'll be apt to sell at exactly the worst time. By contrast, if you have a good sense of the business and trust it, it can pay off even through adverse stock movements.

Netflixis a great example of this phenomenon. Investors fled the stock in droves when it appeared the company had made a huge strategic error in its handling of the split of its DVD and video-streaming businesses. Yet the fundamental strength of the streaming unit had never really suffered any lasting damage, and shares bounced back relatively quickly to reach new highs. Yet many fearful investors sold at the lows and suffered huge losses while missing out on its eventual recovery. The best way for any growth investor to avoid that mistake is to know why you like a company and stick with it.

Matt Frankel: One thing to keep in mind is that while high-growth stocks often don't pay dividends, this doesn't have to be the case, and vice-versa. Whether a company pays a dividend and its potential for future growth are not necessarily related.

Of all of the stocks Selena and Dan mentioned, not a single one pays any dividend. The same can be said for many other popular high-growth stocks such as Facebook, Twitter, and Tesla Motors. As a general rule, growth investors aren't concerned about dividends, and don't expect their growth stocks to make distributions -- at least not right away.

On the other hand,high growth and dividends aren't necessarily mutually exclusive. For example, Starbuckshas nearly doubled its earnings since 2011 and is projected to grow its bottom lineat 18% per year for the next three years, according to S&P. Although the 1.35% dividend yield won't attract true income seekers, it has increased every year since the company started making payouts in 2010. The net result is that Starbucks has the potential to produce a rapidly growing stream of income for years to come.

Other dividend stocks that are projected to claim double-digit earnings growth in the coming years include American Expressand Southwest Airlines. My point is that, just because a stock pays a dividend doesn't mean that it should be excluded from your "high growth" list.

The article 3 Things Every High-Growth Investor Needs to Know originally appeared on Fool.com.

Dan Caplinger owns shares of Starbucks. Matthew Frankel owns shares of American Express. Selena Maranjian owns shares of American Express, Baidu, Gilead Sciences, Netflix, and Starbucks. The Motley Fool recommends American Express, Baidu, Gilead Sciences, Netflix, Starbucks, and Under Armour. The Motley Fool owns shares of Baidu, Gilead Sciences, Netflix, Starbucks, and Under Armour. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.