Investing Basics: Investing in growth stocks with investment trusts

How closed ended funds can support your growth investing efforts…..by Pascal Dowling

 
After the financial crisis of the late 2000s, growth investing firmly established itself as the dominant investment style. Highly valued stocks, particularly in the technology sector, massively outperformed the rest of the market and drove a large chunk of the gains global equities produced.

Investors were putting their faith, here, in the future of these companies which – while they might not have been very profitable at the time – were viewed as tomorrow’s winners and, in many cases, were priced as if they were far more profitable than they actually were. In contrast, value stocks, companies which are ostensibly priced cheaply given the strength of their current earnings ‘today’, tended to either lose value or produce anemic returns.

More recently, value has staged something of a comeback, and recent years have seen the market veering between these two styles in a rather giddying fashion. Whether or not one will dominate the other for any length of time going forward is hard to say. Nonetheless, lots of investors are still likely to want some exposure to growth stocks in their portfolio, regardless of which investing style is in fashion at a given moment in time.
 

What is growth investing?

 
Growth investing is best defined by a couple of features. The main one is that investors are happier to pay for stocks, or other assets, with high valuations on the assumption they’ll deliver even higher valuations, mainly because of earnings growth.

For example, imagine a company that has shares which cost £10. In our scenario, based on its current profitability and performance, those shares ‘should’ be worth £5.

A growth investor, however, might believe the company is going to be worth 10x its current valuation in a year’s time. As a result, they’d be happy to pay £10 for its shares, even if the company is overvalued today, because they believe its future growth will justify doing so.

Cosmetics conglomerate L’Oreal provides us with a real-life example of this. Its shares were trading at 281x earnings back in 1973. Investors at the time could have fairly described them as highly priced as a result. And yet anyone buying them would have seen annualized returns of 7% up until 2019, making it a great investment.

Beyond being willing to pay for what seem like pricey shares, growth investors often focus much more on capital gains than generating income. Unlike other investors, who may want a balance of capital gains and dividends, growth investors are more likely to try and maximise the value of their holdings and don’t tend be overly concerned about receiving cash from them – at least until they sell them.

To understand this difference we can look at the S&P 500. From the start of 1990 until the end of 2015 the index returned 517%. But if you were to reinvest dividends that companies in the index had paid out during the same period, that percentage goes up to 989%.

If there was a fund tracking the index, growth investors would be more likely to go for one that reinvested the dividends. They’d want a higher total return by the end of the period. In contrast, investors that wanted income would be more likely to invest in a fund that paid out dividends, as they look for both capital gains and cash.
 

Why growth investing is harder than it looks

 
Looking back on strong performers like L’Oreal makes growth investing look deceptively easy. We see the subsequent success of a company and think it must have been obvious that investing was the right move to make.

To take a more recent example, many people today would say buying Microsoft shares in the late 2000s was a no brainer. The reality is lots of investors and members of the media were saying the technology giant had peaked and was past its prime at that point in time, so buying its shares was not an easy or obvious choice to make.

The other challenge growth investors face is being sucked into bubbles and hysteria. Growth investing is mainly predicated on a firm performing well in the future. Novel technologies or an exciting new brand may dupe investors into thinking this is going to happen. The herd mentality then gets to work, making more and more people think a company is going to succeed and is thus worth paying any price for.

History is replete with examples of this. Famous mathematician Isaac Newton, for instance, purportedly lost £20,000 (over £2m in 2021) in the early 1700s, when he got sucked into the South Sea bubble, which promised investors massive returns from businesses in South America.

More recently, huge numbers of investors were wiped out by the ‘Dot Com’ internet stock bubble of the late 1990s and early 2000s.

One of the more famous companies involved in this was Cisco. The software company’s shares hit an all-time high of $80.06 in March 2000, at which point they were trading at 201x earnings. Unlike L’Oreal, the company did not go on to generate fantastic returns for investors. In fact, its shares were still trading below that peak in early 2022.

In short, growth investing can be tricky because we overestimate how simple it is based on past performance and can easily get carried away by future promises, which lead to market bubbles and overvaluations.
 

Growth investing with investment trusts

 
These potential problems are part of the reason many investors turn instead to investment trusts when looking to buy into growth companies.

Investment trusts are managed by a team of professional portfolio managers and have the ability to scour the market for the best growth investments. There are no guarantees they’ll succeed but investing in a trust is a way of accessing this expertise and the potential benefits, in the form of higher returns, that it brings.

Investment trusts also typically hold a range of companies, providing trust shareholders with exposure to a diversified portfolio of stocks. This means individual investors have the potential to access a broad portfolio of growth stocks through one investment, something that can be extremely time-consuming to do alone.

It’s also worth keeping in mind that some growth stocks may be hard for investors to access or assess themselves. For instance, small cap stocks in the UK or major companies in Asia can be hard to perform due diligence on and may not even be available for individual investors to access via retail brokerage platforms.
 

Investment trusts vs open-ended funds for growth investing

 
Investment trusts are arguably much better suited to growth investing than their open-ended counterparts.

For one thing, growth investors tend to want to max out their capital gains. But open-ended funds are usually forced to hold a sizeable amount of cash, or other liquid assets, in order to meet redemptions from investors.

The result is that, even if an open-ended fund has a strong portfolio, it’s performance can be stunted by the liquid assets it has to hold. Investment trusts don’t have this problem and can allocate more of their funds to the stocks they want to invest in, boosting returns in the process.

Similarly, open-ended funds cannot use gearing – borrowed money placed into the same investments as shareholders funds – to enhance their returns. Investment trusts can. Of course, gearing can magnify losses, as well as returns, so investors should be aware that using gearing is a double-edged sword.

Finally, investment trusts have the ability to pay a dividend to their shareholders, even if their underlying portfolio isn’t generating income. Some growth investors may not care about receiving a dividend but many do feel as though they have to sacrifice income if they put money into growth stocks. The reason for this is that many growth stocks do not pay dividends, with the companies behind them often preferring to reinvest capital to generate further growth.

Investment trusts can counter this by paying a dividend from capital, meaning investors do not have to give up receiving dividends, even if they’re investing in the sorts of growth stocks that don’t pay them.
 

Investment trusts for growth

 
Identifying a set group of growth-focused investment trusts isn’t the easiest thing to do. The Association for Investment Companies does not segment trusts according to their investment style. Instead it tends to bracket together trusts that focus on similar asset classes.

At the same time, some investment trusts don’t focus solely on growth stocks. They hold a mix of value and growth stocks or fluctuate between the two over time.

All is not lost, however, as most trusts will have a stated strategy and make it explicit as to what investment style the managers prefer. You can also look at the trust’s factsheets and financial reports to see what assets they hold.

At the same time, certain sectors of the market are much more likely to be growth-oriented than others. For example, trusts that invest in the technology sector or small caps are more likely to have a growth strategy in play than others investing in large-cap UK stocks.

In short, investors performing some basic due diligence on a trust prior to investing, will be able to see if it’s one that focuses on growth stocks.