Will growth stocks lead the next market rally?

Business development to success and FTSE 100 250 350 growth concept.

The term ‘growth stocks’ tends to mean companies with decent annual gains in earnings over several recent years. Will such beasts be among the first shares to rally when the markets finally shrug off their current bout of bearishness?

I think that’s a good question. But, to me, the answer doesn’t hang neatly over rigid categorisation. I don’t think it’s desirable to shoehorn companies into labels such as ‘growth stocks’, ‘value stocks’, ‘income stocks’, and others.

Growth is part of value

Billionaire investor Warren Buffett doesn’t label stocks like that either. He’s often quoted as having said, “Growth and value investing are joined at the hip”. And quite early on in his investing career, he evolved from being a short-term bargain hunter into a long-term durable competitive advantage investor.

I pinched that description of the evolution of his style from a book called The Warren Buffett Stock Portfolio by Mary Buffett and David Clark. And the studies of Buffett’s past investments featured in the book make it clear that he targets businesses with the potential to grow. But as well as rising earnings, he looks for a “fair” valuation before buying. And that, to me, is the application of growth and value joined at the hip. Or another way of looking at it is that growth is part of value.

And I’m getting excited right now because I remember investing in the aftermath of the bear market following the financial crisis of 2007/08. The sell-off in the markets was brutal back then. But it left many growing businesses on modest valuations. And I remember running stock screens around 2010 that identified many UK firms with rising profits and single-digit earnings multiples.

They were great companies with often durable competitive advantages. And over several following years many of those stocks rose to become multi-baggers, but not all of them. The successful ones were driven by two things. The first was the continuing progress of the businesses and their earnings. And the second was the way the market recognised the progress by re-rating each company’s valuation. Companies that used to have earnings multiples of, say, eight later had multiples above 20 or so.

Value could be building now

And we could be heading for similar conditions now as those seen around 12 years ago after that great bear market. So, for me, it’s important to focus on my watch list to identify the businesses that are trading well and growing. Some of them could soon have stock prices that assign fair valuations. And that could lead to tempting investment potential as before.

In fairness, though. Many will think of growth stocks as being those with exceptional rates of earnings growth. But high growth businesses often attract eye-popping valuations. And it’s many of those that have crashed so hard recently. Will they be the first to lead the next market rally? I’m cautious about that. Because even now, valuations can be high. It’s just that they are no longer stratospheric. And it’s possible the market will have learnt its lesson about excessive exuberance with those previous high-flying names.

New stocks often lead new bull markets higher. And I’m aiming to find them by focusing on the news and fundamentals of each individual business.

The post Will growth stocks lead the next market rally? appeared first on The Motley Fool UK.

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Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.