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There is no infalible formula to obtain market-beating returns from your investments. However, positioning your portfolio in companies with superior growth can be a smart strategy to maximize returns. When you think about it, a stock is simply a share in an ownership of a business. This means that over the long term the value of those shares is driven by the value of the underlying business.
Assuming that all other variables remain the same, a business which is growing more rapidly should deliver superior returns than a company which is expanding at a slower speed. With this in mind, let's discuss three big reasons to love growth stocks.
1. Visionary leadership
The best growth companies are led by visionary leaders who know how to stay ahead of industry trends and capitalize on all kinds of emerging opportunities over the years. The importance of having the right leadership can hardly be overestimated, as it can have a massive impact on shareholders' returns over time.
Amazon (NASDAQ: AMZN) is a prime example to consider. Back in 1995, the company was just an online bookstore generating only $511,000 in sales. Two decades later, Amazon is the undisputed king in online retail, and the business is expected to generate $136.45 billion in revenue during 2016. Even more impressive, total revenue during the second quarter of 2016 grew 31% to $30.4 billion, a level of performance which is quite exceptional coming from a company as big as Amazon.
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Amazon CEO Jeff Bezos is one of the most innovative business leaders of our times, and his leadership has made all the difference in the world for investors in the company. In addition to consolidating Amazon's position as the top player in online retail on a global scale, Bezos has led Amazon to invest massive sums of capital in its cloud computing business over the past several years -- a remarkably smart move.
Based on financial reports for the second quarter of 2016, Amazon's cloud computing division, Amazon Web Services, is now generating nearly $9.9 billion in annual revenue, growing by 58% year-over-year last quarter and accounting for 8% of all company-level revenue. On a forward-looking basis, chances are that Amazon Web Services will remain a powerful growth driver for investors in the company over the years ahead.
2. Superior profitability
Not every growth company necessarily generates above-average profitability; however, new technologies and smart business models can do wonders in terms of retaining a big share of revenue as profits. Even when a company is aggressively investing for growth, innovative businesses can be fertile ground for superior profitability.
Facebook (NASDAQ: FB) is investing massive amounts of money in people and technology, so total expenses grew 33% year-over-year during the second quarter of 2016. Nevertheless, revenue still outgrew expenses during the period -- sales jumped 59% versus the second quarter in 2015. In this context, operating margin increased from 31% of sales to 34% of revenue.
Facebook is also moving beyond text-based ads toward richer forms of content like videos and pictures. This is creating more engagement among users and better results for advertisers, which is ultimately reflected in more valuable ads and higher profit margins.
3. Volatility means opportunity
Growth stocks tend to be far more volatile than stable and mature companies. This can be interpreted as an important risk factor to keep in mind; on the other hand, volatility can be a major advantage for opportunistic investors.
Netflix (NASDAQ: NFLX) is at the forefront of the online streaming revolution. This means extraordinary potential for expansion, but financial performance can be quite unstable on a quarter-to-quarter basis. Disrupting a huge market such as the TV industry can produce bumpy growth, and investors tend to overreact to negative news in the short term.
Netflix stock has delivered massive gains for shareholders over the last decade, but the path to those gains has been quite rough. Investors who were smart enough to buy on temporary dips could have obtained outsized gains over time.
In fact, Netflix stock is now trading 30% below its highs last year, as the company's growth rates have disappointed investors over the last two consecutive quarters. Expectations are quite demanding for a high-growth business such as Netflix, and the market can be unforgiving when those expectations are not met.
Subscriber numbers for the second quarter of 2016 missed both the company's own guidance and Wall Street forecasts by a considerable margin, generating plenty of negativity around Netflix stock.The company implemented a price increase for new members two years ago, but long-tenured customers were grandfathered in, with their subscription costs remaining relatively low for two years. Netflix is now un-grandfathering those customers, which is interestingly producing higher-than-expected churn rates from some members were were not being un-grandfathered in as they mistakenly interpreted the media coverage about the change as an impending price increase.
That's no reason to despair, though. The long-term growth story remains pretty much intact, and short-term volatility seems to be creating a buying opportunity for investors with a long time horizon.
Top-quality growth companies allow you to invest your money with some of the most visionary business leaders of our times, they can also offer exceptional opportunities for superior profitability, and price volatility can create compelling opportunities for smart investors. That's not only one, but three powerful reasons to love tech stocks.
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Andres Cardenal owns shares of Amazon.com and Netflix. The Motley Fool owns shares of and recommends Amazon.com, Facebook, and Netflix. 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.