3 Reasons to Hate Growth Stocks

By Markets Fool.com

Image source: Getty Images.

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It's hard to admit this over the Internet, but I'm one of the haters.Specifically, I go through periods during which I hate growth companies, and by extension, their publicly traded shares.

A growth company is, by definition, one that exhibits higher-than-average revenue growth. The management team of the typical growth company reinvests current profits back into the business in the belief that this will produce a higher rate of return than other investments available to the company. As a rule, growth companies don't pay dividends.

Buying and profiting from the shares of growth companies seems simple in theory, but in practice, with real money at work, the process can be maddeningly difficult. Growth stocks often exhibit a higher beta -- a measure of volatility -- than the overall market, causing even shareholders with a long investment horizon to endure periods of second-guessing.

Personaly, I gravitate toward value situations, where I can arrive at an opinion that, for tangible reasons, a certain company's value is being discounted or ignored by the market.Solid, boring dividend stocks, with the potential for increased yield after a few years of steady dividend reinvestment, also appeal to my mindset. I find these easier to evaluate than stocks that may or may not live up to their potential as growth vehicles.

To complete this rant, I offer up, only half-facetiously, three reasons investors may find to join me in hating growth stocks. But maybe by engaging in this exercise, we'll also uncover the means to allow us to invest wisely in a growth stock or two.

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1)Valuing growth stocks can be immensely difficult

Growth companies are often characterized by their attempts to aggressively win market share. Many focus more on revenue than near-term profits.

For example,Splunk Inc. , a company that enables corporations to extract analytical information from the machine data they generate, is scaling up sales at an incredible clip. It's also losingquite a bit of money along the way:

The graph above represents a simple exercise you can perform at home, and you don't need charting software to do it. Simply review the multi-year revenue and income trends of growth stocks you're interested in, or already hold. Not all growth stocks run at losses. Yet many that you'll encounter, at some point in their development, exhibit divergent trends resembling Splunk's.

Of course, the goal is for such companies to arrive at a relationship between revenue, research and development, sales and marketing, and operational costs, that will turn losses into net income. Once revenue and profits are both moving positively in tandem, it becomes easier to place a common-sense valuation on a stock.

In the absence of profits, valuation is more guesswork than science. For now, Splunk investors have to be content with the fact that the company is trading at 4.7 times forward one-year sales, which is nearly triple the 1.8 price-to-sales ratio of the overall market, as represented by the S&P 500 Index.

2) Investing in growth companies often requires specialized knowledge

Tantalizing and vexing are two adjectives that describe the paradoxical opportunities available in certain growth stocks, especially in the tech industry.

A good illustration isArista Networks , which produces specialized cloud-based networking equipment -- in particular, data-center switches that compete with switches of the much-larger Cisco Systems . Arista has no problem increasing sales, as well as its profits; both have grown at a rate of approximately 30% during the last trailing 12 months.

Yet, with less than $1 billion in annual sales, Arista is essentially a niche company. To invest successfully in Arista Networks, you have to be somewhat knowledgeable about the long-term total addressable market (TAM) for the company's equipment, its prospects vis-a-vis Cisco, and its ability to continue to innovate and sustain an attractive growth rate.

For shareholders with both adequate investing chops and a thorough knowledge of the networking sector, this probably isn't a problem. But for those without a comprehensive understanding of the company's basic products, it may be problematic to assess what to do if and when Arista encounters its first significant roadblock to growth.

3) Growth stocks generate short-term handwringing and angst

Above, we see perennial growth stock favorite Netflix, Inc.'s price performance during the last 12 months. Those who have held Netflix for long periods have been richly rewarded: The content company's five-year stock-price return is north of 155%, and over a 10-year period, Netflix has returned a stunning 2,270% to investors.

But a hallmark of the most-successful growth stocks is extreme volatility over short periods, as investors and analysts wrestle with just how much of a premium to pay at the moment for the growth attracting the interest in the first place. Bouts of eager buying are succeeded by quick dumping of shares, and these cycles are often driven by an over-fixation on immediate news items that have little bearing on the over-arching, long-term investment thesis.

If you bought Netflix 12 months ago, you can certainly understand this, as your capital has fluctuated by more than 50%, only to land at breakeven today.

Three reasons to dial down hate

You may agree with me that hate without constructive action is simply self-debilitating, solet's focus on positive ways to make use of the points above.

First, we can mitigate some of the valuation ambiguity of growth stocks without current earnings by lining up price-to-sales ratios of stocks within the same industry. When valuation becomes difficult, it never hurts to compare like to like. In the example of Splunk, we can research the price-to-sales ratios of its peers, and gain some context before placing a "buy" order.

Second, for a growth stock like Arista, which is riding high on a specialized technology, we should take the leap, and become deeply knowledgeable about the company's offerings. In this age of widely disseminated, free information, there's really no excuse not to.

We should read trade journals, blogs, and of course, quarterly reports, especially the section required of all corporations by the SEC entitled "Management's Discussion and Analysis." Between these sources, we should be able to understand, in comprehensible English, what exactly a niche company's business proposition is, and how its prospects stand.

Finally, after identifying a promising growth stock, we should try our best to stretch out our investment horizon. This helps in weathering volatility, and better, if an investment idea pans out, enables us to maximize the gains the stock is capable of delivering. For what better medicine exists than profits to turn investment hate into love?

The article 3 Reasons to Hate Growth Stocks originally appeared on Fool.com.

Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Arista Networks, Netflix, and Splunk. The Motley Fool recommends Cisco Systems. 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.