There are hundreds of UK growth stocks that I could consider buying with my hard-earned money. The nature of these stocks is that most are higher-risk investments, but with large potential for share price appreciation.
Get the right one and it could be like buying Nvidia shares in 2019. Get it wrong and the company could go bust. Here are the mistakes I now try and avoid when picking.
Checking for valuation
The first one is to look at valuation metrics. For example, consider Auto Trader (LSE:AUTO). I have owned the stock in the past, but don’t currently. The stock’s up 12% over the past year. Given the long-term share price appreciation, I’d say many regard it as a UK growth share.
The increase in revenue over the past few years shows the company’s enjoying a strong period. Revenue in 2020 was £262.8m. This has risen each year since, with the 2023 results (published earlier this year) showing revenue of £570.9m. Net profit has also jumped over this period.
So far, so good. Yet let’s look at the price-to-earnings ratio. It’s 26.82. By comparison, the FTSE 100 average ratio’s 14.64. So Auto Trader is almost twice as expensive as the average stock in the index. Of course, not all companies are doing as well as Auto Trader. But in my view, it makes the stock potentially overvalued.
The risk to me is that if I bought it now, the share price could move lower in the coming year to reflect a more accurate value.
Ignoring short-term noise
Another mistake I try to avoid is confusing speculation with genuine long-term investor interest. Growth stocks naturally attract a lot of attention, even from short-term traders trying to make a fast buck. There’s nothing wrong with this, but it can distort the share price for a period.
These fast money buyers can trade the stock and sell it within just a few days. As a result, the stock can be volatile and erratic. I want to be careful not to be drawn in to buying simply due to a spike. Rather, if this is just speculative buying based on rumours, the share price will likely fall back.
Instead, I want to look beyond the noise and look for companies that are attracting investors for the right reasons.
Hunting for small-caps
Finally, I want to look outside of the main large-cap pool of stocks to try and find serious growth potential. I used to just want to stick to FTSE 100 shares. Although this is safer in some respects, the companies in the index already have multi-billion market-caps. This means it’s going to be harder to get explosive share price growth going forward.
Rather, if I look in the FTSE 250 or even at small-cap names, there’s more potential for gains if everything goes right. I do need to be aware that buying small-cap or penny stocks is much higher in risk. Yet given the low market-cap, this is the area that I feel has the best potential.
This post was originally published on Motley Fool
