Investing in growth funds is an attractive idea – but it’s wise to diversify to reduce the risks.
Investing for growth is a popular strategy and one that suits many Isa investors in the run-up to retirement.
The idea is to hold companies whose profits and share prices are likely to dramatically outperform the stock market over the next few years and then sit back and reap the rewards.
Many such companies are at an early stage in their lives and are keen to reinvest profits back into supporting future development. However, they can also be mature names that perform well in all conditions, have consistent earnings, and pay dividends to shareholders.
In an ideal world, an investor following this strategy would pick the next Microsoft before it comes to prominence. Unfortunately, while some companies will see their valuations soar, plenty fail to live up to expectations.
“Growth stocks have the potential to become overvalued after a period in which they are in demand by investors and suffer significant falls,” says Patrick Connolly, a certified financial planner with Chase de Vere. “There will be times when the strategy does well and when it performs badly.”
The main risk is a company not delivering on the growth that it has promised – or investors getting too excited about its potential and this is reflected in an inflated share price, according to Adrian Lowcock, investment director at Architas, the multimanager.
“The result is that growth companies become overvalued and the share price comes crashing back to earth when reality hits,” he says.
However, growth stocks can be considered by a wide range of investors, according to Mr Connolly, including those prepared to take high levels of risk to generate superior long-term returns.
As is often the case, the most sensible option is to opt for an investment fund that puts money into a wide range of companies. A decent amount of diversification should help protect your overall portfolio from the impact of companies that fail.
Mr Lowcock believes managers pursuing a growth strategy need to understand the risks of each stock – and how they stack up against other names in their portfolio to ensure the level of overall risk being taken is appropriate.
“A good understanding of corporate balance sheets, cash flow and profit is essential to understand the risks in the business,” he says. “Fund managers also need knowledge of the wider business and the strengths and weaknesses of the management team.”
Darius McDermott, managing director of Chelsea Financial Services, says sentiment towards growth stocks is currently positive, with valuations reliant on these companies delivering as expected in the future.
“The underlying stocks [companies] in growth funds tend to be more expensive than others in the market, especially now when economic growth has been so flat for so long,” he explains.
“Investors are willing to pay more for companies that are growing at a faster pace.
“There are also different types of growth – solid and boring or exciting and more volatile. Both can be rewarding; it’s just down to the individual investor.”
While acknowledging that some companies look expensive, Mr McDermott believes a growth strategy still makes sense, with lots of opportunities in the market where companies should be able to grow irrespective of the macroeconomic environment.
“Like all types of fund, good growth fund managers will take active bets,” he says. This means they will perform differently from a tracker fund that simply replicates performance of a stock market index.
“Cost is also a factor, as is a clear and understandable process, so investors know what to expect,” he says.
He also prefers funds that aren’t too large as this enables managers to invest in small-and medium-sized companies that are at an earlier stage in their growth. Of course, there are exceptions to this rule.
“The Fundsmith Equity fund* is large, but the manager is very experienced so this doesn’t impact on his process,” he adds.
For those looking for exposure closer to home, Mr McDermott suggests the Marlborough UK MultiCap Growth fund is worth considering.
“It invests in small, medium and large UK companies that are leaders in their sectors and can grow regardless of the prevailing economic landscape,” he explains.
“Marlborough has a fantastic track record when it comes to stock-picking skill and this fund is no different.”
Another possibility is the Matthews Pacific Tiger fund. “Matthews is a specialist Asian equity fund house based in San Francisco with a large investment team from diverse backgrounds,” he says. “The team has local knowledge and its members speak 13 different languages between them.”
Those who can’t decide on any one fund or region could consider Jupiter Merlin Growth, a high-conviction fund of funds that is run by one of the most respected investment teams.
“Most of the portfolio is held in the top five fund holdings, although underlying stocks remain plentiful and diversified,” says Mr McDermott. “The process is simple: assess the macroeconomic environment, identify the best people, construct the portfolio, then monitor and modify.
* Member of the Moneywise First 50 Funds for beginners.
One to watch: Old Mutual UK Mid Cap*
The aim of the fund, which is run by Richard Watts (pictured above), and is a member of Moneywise’s First 50 Funds for beginners, is to provide capital growth from investing primarily in a portfolio of medium-sized companies.
Adrian Lowcock, investment director at Architas, likes the fund’s focus on identifying companies with dominant market positions that can grow their businesses.
“Mr Watts is looking for opportunities which the wider market has not fully considered and, therefore, has undervalued the shares,” he says.
The largest sector weighting in the fund is fi nancials at 26% of the portfolio, followed by 24% in consumer services and 20% in industrials. Other exposures include consumer goods (13%), technology (5%), healthcare (2%), and basic materials (2%), according to the most recent fund fact sheet.
Its 10 largest stocks, meanwhile, include internet fashion retailer Boohoo.com with a 6% share, followed by media outfit Ascential with 5%, and 4% in SSP Group, a catering company.
The fund has generated significant long-term outperformance of its benchmark, according to Mark Dampier, research director at Hargreaves Lansdown. “Our analysis suggests the manager’s performance has been driven by astute stock picking,” he says. “With the support of a talented team of fund managers investing in the UK, we feel he has the ability to deliver good, long-term returns.”
*Member of the Moneywise First 50 Funds for beginners. For more information visit Moneywise's First 50 Funds for beginners.