Neuroeconomic studies have repeatedly proven that most investors are influenced by their emotions (Greed, fear, familiarity with the stock, etc.) when making investment decisions. Every successful value investor, including Warren Buffett, has learned to understand his emotions, and rather than giving in to them, using them as just another factor in making decisions. For example, a value investor will never invest in shares of a company where he works, based on familiarity, but use the familiarity to make an informed decision about the actual value of the company.
Growth stocks, on the other hand, tend to go in the opposite direction. Crudely speaking, it is a game of high stakes, where a fledgling company with great potential either hits the roof or shoots for the moon and gets wiped off the rug. It is these adrenalin pumping uncertainties, with possibilities of extremely high gain that attract, time and again, otherwise sober investors to make investments in growth stocks. Since it’s nearly guaranteed that every investor will take the plunge into growth stocks at some time or the other, it might be an innovative idea to develop specific ground rules for making investments in growth stocks.
A growth stock is not necessarily a new company. Even established companies and market leaders tend to go shoot up on the specific occasion, such as winning a corporate turf war with a competitor, a comprehensive overhaul to come out of the doldrums or with the release of a successful new product. The key is to find sound companies which are experiencing a downturn, because of misguided company policies, rather than overall market declines. That means the market has demand and the company has the potential and resources, but it just hasn’t been able to get things right.
The natural tendency is to ignore these stocks, and the market downgrades them. This is ripe fruit, ready for the pickings, by both value investors and growth stock buyers. The company will fight its way back into the reckoning, and the day it does, the stocks will shoot back up to the average level. As an example, consider the ongoing struggle between open source proponents and Microsoft. Most investors a year ago were downgrading Microsoft as a has-been, losing on all fronts, from search to browsers. A growth or value investor, at that point, should have had an internal bell ringing off, telling him that Microsoft is not going anywhere, and they have the muscle to keep hammering until they hit the mark.
Microsoft released Internet Explorer 7, which ended the browser wars, they released Windows Vista, they released Live search, and they released a series of blockbuster games on the Xbox platform. Today, the market is looking at Microsoft with renewed respect. That is growth, or you can call it re-growth since it’s effectively a fresh start.
Whether it’s a startup or a market leader, the trick is to be able to spot the window when the stock is down, but not out, and about to surge. If you can find this sweet spot for an established company facing a temporary headwind, that reduces the risk of the crash and burns while keeping the growth option alive.