7 Ways to Minimize Your Risk in Growth Stocks

growth stocks - 7 Ways to Minimize Your Risk in Growth Stocks

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Investors have been pouring money into growth stocks, which are firms that are expected to increase their revenue, cash flows, or earnings faster than the average business in their sectors. In the past decade, investing in growth stocks — especially in the technology sector — has typically meant higher portfolio returns. Such returns have also brought higher degrees of risk, which can mean stomach-churning volatile market days for retail investors. Therefore, let’s look at seven ways to minimize your risk in growth stocks and discuss several stocks that may pique your interest.

In equity investing, one of the most important classifications used is growth investing vs. value investing. The risk and return profiles of growth stocks are quite different than those of value stocks, whose prices tend to be lower than their intrinsic value. For example, value stocks may be underpriced relative to their current assets or cash flows.

On the other hand, growth stocks tend to have higher prices. These fast-growing companies usually do not pay dividends, but instead reinvest their available cash back into the business. As a result, investors want to be rewarded with capital appreciation; i..e, higher stock prices.

Research led by John Campbell of Harvard University highlights, “there is more to growth than just ‘glamour.’” The authors highlight the importance of cash flows, low levels of debt and cyclicality (i.e., the less cyclical the firm, the better) for the potential success of growth stocks.

Growth business are often the ones that innovate — be it a new product, service, or business strategy. In turn, that innovation usually becomes the competitive edge. And they may also use acquisitions to increase market shares in a sector.

So, with all of that in mind, here are seven ways (in alphabetical order) to minimize risk in growth stocks:

  • Asset Allocation
  • Debt Levels
  • Diversification Across Market-Caps
  • Free Cash Flows
  • Hedging
  • Revenue Growth
  • Social Trends

That said, let’s take a closer look at each one.

Risk Tolerance in Growth Stocks: Asset Allocation

According to research led by Keith Brown of the University of Texas at Austin:

“Asset allocation—the process of distributing investment capital across the various asset classes in an allowable universe—is widely regarded as one of the most important decisions an investor faces… [A]n investor’s initial strategic asset allocation decision is the most important determinant of the portfolio’s investment performance.”

Therefore, investors who would like to decrease portfolio volatility and risk should consider diversifying their capital across different asset classes — including growth stocks.

For instance, a large number of investors include some bonds as well as other asset classes. This includes currencies, commodities and real estate in their portfolios. Stocks and bonds are typically inversely correlated, and stocks increase when bonds fall.

Moreover, including exchange-traded funds (ETFs) that provide exposure to other asset classes could be appropriate for most portfolios that also have growth stocks. Examples of such funds would be the Vanguard Total International Bond ETF (NASDAQ:BNDX), the iShares Residential and Multisector Real Estate ETF (NYSEARCA:REZ), the First Trust Multi-Asset Diversified Income Index Fund (NASDAQ:MDIV) or the SPDR Gold Shares (NYSEARCA:GLD).

Debt Levels

Investors who would like to minimize their risk in growth-company investments should keep an eye on the debt levels of the business. Many companies have some level of debt that enables them to carry out strategic plans and long-term objectives.

However, having too much debt on the books can end up restricting management’s operational flexibility. If revenues were to drop, financial problems could easily pile up. For example, in a contracting economy, debt-heavy growth firms tend go broke first. Excessive debt hurts companies. Thus, debt levels should be manageable.

It may also be prudent to compare a company’s debt levels to its industry peers. Investors should also track changes in debt levels over time. In other words, you want to know if the company is paying-off debt or simply borrowing more. Expensive acquisitions that drive up debt levels could also be a warning sign for the stock price.

So, what are some of the companies that have low levels of debt and are still growing? You may want to do further research on the following:

  • Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), up 16% year-to-date (YTD),
  • Facebook (NASDAQ:FB), up 31% YTD,
  • Intuitive Surgical (NASDAQ:ISRG), up 25% YTD,
  • Nvidia (NASDAQ:NVDA), up 133% YTD,
  • Regeneron Pharmaceuticals Inc (NASDAQ:REGN), up 54% YTD,
  • Skyworks Solutions (NASDAQ:SWKS), up 27% YTD.

These companies have robust balance sheets, in part, thanks to low debt levels. And we can expect them to create shareholder value in the coming years, too.

Risk Tolerance in Growth Stocks: Diversification Across Market-Caps

In addition to having exposure to growth and value stocks, long-term investors typically diversify across sectors, regions and market capitalization (cap). Each of these categories has different risk/return profiles. Broader market conditions and the state of the economy also affect how they behave.

To arrive at the market cap, you would need to multiply the number of shares outstanding by the current share price. For example, a company with 30 million shares selling at $20 a share would have a market cap of $600 million.

So, in order to minimize risk exposure in growth stocks, investors can decide to have exposure to small-caps, mid-caps, or large-caps. Most U.S.-based brokers define a small-cap company as having market cap of between $150 million and $2 billion. Most mid-would have market caps between $2 billion and $10 billion. And the rest would be considered large-caps.

However, historically, dollar ceilings for each cap category has gone up. Also, some ETFs describe themselves as “small-cap” or “mid-cap,” but include companies whose market-cap is larger than the definition.

A firm’s market value usually affects investor expectations about its future. Small-caps typically have a more domestic focus, as most of their revenues depend on operations in the U.S. On the other hand, mid-cap stocks have more established operations than small-caps. Thus, they are regarded as less risky. Yet, they normally have less muscle to weather economic storms than large-caps.

How do you find growth companies across different market caps? One way could be to look at a range of ETFs. You may want to start your research with the Vanguard Small-Cap Growth Index Fund ETF Shares (NYSEARCA:VBK), the Vanguard Mid-Cap Growth Index Fund ETF Shares (NYSEARCA:VOT), or the iShares Morningstar Large-Cap Growth ETF (NYSEARCA:JKE).

Free Cash Flows

Free cash flow is another way to look at the risk tolerance in growth stocks. According to three professors from Kardan University, free cash flow is:

“…a measurement tool to determine how much cash a business generates after doing its accounting for the essential capital expenditures such as buildings or equipment and equally this cash can be used for expansion, dividends, reducing debt or other purposes… Free cash flow allows a company to avail opportunities which enhances the shareholder value. Furthermore for a company to have growth it must keep enough of cash to be able to reinvest, therefore Free cash flow tends to be a measure of a company’s growth… .”

Several of the high tech names that have been growth darlings of the Street have had high free cash flow levels over the past several years. They include Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Texas Instruments (NASDAQ:TXN) and Walmart (NYSE:WMT).

As a result, they have been able to return cash to shareholders, make strategic acquisitions, innovate to grow their businesses or save that cash for a proverbial rainy day when the economy contracts. And their stock prices have been a testament to their growth.

Risk Tolerance in Growth Stocks: Hedging

The risk level of an investment, such as a growth stock, is generally related to the potential returns it offers. For instance, academic research shows prices of growth stocks are likely to suffer from negative earnings reports. As investors expect exceptional future earnings potential, they usually hit the sell button following a quarterly result.

On Oct. 14, content delivery network (CDN) company Fastly (NYSE:FSLY) lowered guidance for its third quarter and the stock plummeted 25% after hours. Yet, the company’s shares are still up over 319% YTD.

Market participants can usually decrease the level of risk with diversification and hedging, which can help mitigate against investment risks. Through hedging, an investors uses one financial instrument to minimize the impact of adverse price moves in another. Put another way, a hedge usually increases in value when, for example, the value of growth stocks in your portfolio loses value.

Moreover, there are different hedging strategies that can be used to hedge against declined shares of growth businesses. If we return to our Fastly example, investors who had used options to hedge some of the risk, would have noticed their short-term loss could have been less.

Investors who already own FSLY stock may consider using an at-the-money (ATM) or a slightly ITM covered call strategy with an approximately one-month time horizon, like a Nov. 20 expiry. Such a covered call position could offer some downside protection and decrease portfolio volatility, allowing for participation in a potential up move.

However, if FSLY declines substantially over the course of the month, the covered call may not be able to provide enough downside protection. Position monitoring would be required.

Another alternative could be purchasing protective puts on FSLY stock that offer downside protection from the chosen strike price all the way down to zero. It is important to monitor the effect of volatility levels on option prices. We’d typically avoid buying puts outright when volatility is too high, since they can be expensive during these periods.

A final strategy to consider could be bearish vertical put spreads in FSLY stock. Investors need to specify how much downside protection to have, which would influence the amount they pay. That said, put spreads can help eliminate extra for the volatility component in the protection. However, such spreads do not provide as much protection as protective puts.

Finally, investors could also buy an ETF, such as the Cambria Tail Risk ETF (BATS:TAIL) that provides exposure to a portfolio of long put options on the U.S. stock market. It would be a portfolio hedge against market declines and rising volatility, but not against a given stock’s risk.

Additionally, TAIL invests a small percentage (currently about 5%) of assets in a basket of out-of-the-money (OTM) put options on the S&P 500 Index. The rest of the assets are kept in intermediate-term US Treasuries. So far in the year, TAIL is up around 10.4%. However, the fund is not likely to have positive returns in years when markets rise, and volatility falls. All such insurance strategies come at a cost.

In other words, there are truly no free lunches on Wall Street.

Revenue Growth

Most analysts would regard revenue growth as one of the most important factors that affect the potential future stock price of a company. Without revenue, there would be no earnings or eventual profit.

That said, Eli Bartov of Leonard N. Stern School of Business New York University states:

“In the absence of a history of profits and meaningful book values, conventional wisdom suggests that investors rely on revenue as an important financial value driver.”

Moreover, one recent study concluded that:

“Since 2013, Facebook has delivered revenue growth at a CAGR of 38,8%. In 2017 and 2016, revenues grew exceptionally at a rate of 54% and 47%, respectively… Over recent years, Facebook has demonstrated its ability to translate top-line growth into improvements also in bottom-line performance, which has meant that the company has become highly profitable.”

In January 2013, Facebook stock price was about $30. And now, it is just under $270.

Put another way, consistent revenue growth is likely to increase return on equity and separate winners from losers.

Risk Tolerance in Growth Stocks: Social Trends

Last but not least on our list is paying attention to social trends to find growth companies that could fuel portfolios for many quarters. Some of the most successful growth companies of the past have been those that have taken advantage to changes in the society.

This year has so far brought health and economic uncertainties due to the pandemic. In addition, billions of global citizens are shifting to a more “stay-at-home, work-from-home” economy. Another macro change we are witnessing is the rise of electric vehicles (EVs) and alternative energy sources. As a result, share prices of a number of companies have grown much faster than they would have done before 2020.

Several examples that InvestorPlace.com readers would immediately recognize are:

  • BioNTech (NASDAQ:BNTX), up 178% YTD,
  • Clorox (NYSE:CLX), up 37% YTD,
  • Moderna (NASDAQ:MRNA), up 267% YTD,
  • PayPal (NASDAQ:PYPL), up 87% YTD,
  • Peloton Interactive (NASDAQ:PTON), up 366% YTD,
  • Tesla (NASDAQ:TSLA), up 403% YTD,
  • Walmart (NYSE:WMT), up 21% YTD,
  • Zoom Video Communications (NASDAQ:ZM), up 695% YTD.

This year’s changes, although extremely important, are only a handful of the developments that are happening in the society. Paying attention to them to invest in growth stocks could possibly make some investors quite wealthy. And such societal trends tend to outlast regular economic booms and busts.

On the date of publication, Tezcan Gecgil did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Tezcan Gecgil has worked in investment management for over two decades in the U.S. and U.K. In addition to formal higher education in the field, she has also completed all 3 levels of the Chartered Market Technician (CMT) examination. Her passion is for options trading based on technical analysis of fundamentally strong companies. She especially enjoys setting up weekly covered calls for income generation.

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