Investing in ASX growth shares

What are ASX growth shares? 

A growth share is a company that investors expect will grow at a faster rate than the broader market, which is typically measured using the S&P/ASX All Ordinaries Index (ASX: XAO) or S&P/ASX 200 Index (ASX: XJO). 

Growth companies are more likely to be smaller, up-and-coming businesses than larger, well-established companies. They typically focus on growing their sales and market share, possibly delaying profitability to become industry leaders. As growth businesses mature, the focus naturally shifts to maximising profits. 

Growth companies tend to reinvest their earnings during the growth phase rather than paying them out as dividends. This means investors will often not receive income for holding growth shares. However, many will choose growth investing due to the potential for share price growth, which translates into capital gains. 

Why invest in ASX growth stocks? 

A growth investor is looking for shares with faster earnings growth than other companies, which means they may outperform the market over time. Growth stocks tend to have high valuations on a price-to-earnings (P/E ratio) basis but are usually also growing their revenue faster than their peers. 

Growth companies tend to have unique product lines, intellectual property, or technology that gives them a competitive advantage over others in their industry. This can help them build a loyal customer base and significant market share. 

They must continually invest in developing new products and technology to retain that advantage and ensure long-term growth. 

Top growth shares on the ASX

Choosing quality growth stocks can be tricky as the performances of smaller companies with potential for strong capital gains depend heavily on variables such as competition, customer base and market volatility. 

Here are three top-performing ASX growth shares ranked by market capitalisation from high to low.

Xero

Xero provides cloud-based accounting software to small and medium business customers. Founded in 2006, the company now has more than 3.74 million subscribers and leads the cloud accounting market in Australia, New Zealand, and the United Kingdom. 

Xero reported revenue of $1.4 billion in FY23, which represents growth of 28%.  Annualised monthly recurring revenue (ARR) increased by 26% to $1.55 billion. Xero delivered several product updates and new features for customers in FY23, which helped improve average revenue per user by 10%. 

The company's FY23 performance demonstrates its resilience to macroeconomic conditions and the value it provides customers in a challenging economic environment. It remains well-positioned to take advantage of the significant long-term opportunity for cloud accounting as it prioritises disciplined, customer-focused growth.  

Cochlear

This company is a global leader in cochlear implants, which are surgically implanted devices that provide a sense of sound to individuals with hearing loss. Cochlear also manufactures bone conduction implant systems designed to transmit sound vibrations directly to the inner ear through bone conduction.

The company operates internationally, serving customers and healthcare professionals in more than 100 countries. It invests significantly in research and development to enhance its technology and improve user hearing outcomes. 

In FY23, Cochlear reported a 19% increase in sales revenue driven by market growth, improved clinical capacity, market share gains, and COVID-19 catch-up surgeries. Underlying net profit increased 10% to $305 million and is expected to be $355 million to $375 million in FY24. A strong balance sheet and cash flow generation supported a 21% increase in the final dividend, bringing full-year dividends to $3.30 per share. 

Altium

Altium specialises in developing software tools and platforms that facilitate the design of electronic circuits and printed circuit boards (PCBs). The company designs its software to integrate with other software tools commonly used in the electronics industry, streamlining the design workflow. 

Industries widely using Altium products include electronics, aerospace, automotive, and consumer electronics, where PCB design is a critical part of product development. Its clients include Tesla Inc (NASDAQ: TSLA), Microsoft Corp (NASDAQ: MSFT), Amazon.com Inc (NASDAQ: AMZN), Alphabet Inc (NASDAQ: GOOGL), and Apple Inc (NASDAQ: AAPL).

In FY23, Altium reported a 19.2% increase in revenue, which grew to US$263.3 million. EBITDA was up 20.3% to US$96 million. The company has a cloud-first strategy, transforming its product portfolio from stand-alone desktop design software to a connected cloud-based design platform. 

This has allowed it to gain increasing traction with enterprise, as well as mid-market, customers. Altium has provided guidance for revenue of US$315 million to US$325 million in FY24, meaning 20%–23% growth is predicted. 

What to look for when investing in growth shares 

Investors in growth stocks expect strong growth in the underlying company. This can often result in high price-to-earnings (P/E) ratios, making growth stocks appear overvalued. When the market expects a company to grow strongly, many investors remain willing to invest even at high P/E ratios. This is because they anticipate the stock price will appreciate over the long term. 

We can contrast it to value investing, where investors seek good quality stocks trading at attractive prices with lower PE ratios. Another investment strategy is income investing, where investors seek dividend stocks to provide ongoing income. 

Growth stock investing means seeking stocks with substantial room for capital appreciation. Overall, these are typically newer and smaller companies or industry disruptors. They usually offer unique services, products, novel technologies, or intellectual property. They may operate in high-growth industries like technology or biotechnology. 

Growth stocks perform best when interest rates are falling, and company earnings are on the rise. Remember, growth stocks only remain growth stocks while investors think there is a good chance for significant company expansion. Once companies have fulfilled this potential, they may no longer be classified as growth stocks. 

Pros of growth investing 

Potential for capital gains: Growth shares have substantial potential for capital appreciation. For example, investors might consider a biotech company working on a new disease treatment a growth stock because there is potential for huge profits and capital gains if the treatment receives regulatory approval. 

Exposure to emerging trends: Changes in societal trends can hugely impact growth stocks. For example, COVID-19 accelerated the adoption of online shopping, boosting the share prices of companies like Amazon.com, Inc (NASDAQ: AMZN) during the pandemic. 

And the cons

Lack of dividends: Growth stocks tend to avoid paying out dividends because such companies usually reinvest their earnings to accelerate further growth. Investors in growth stocks anticipate making gains via capital growth rather than dividend income. 

Risky: Since growth stocks often trade at premium valuations, negative news or a shift in market sentiment can lead to significant price declines. Investors who buy these stocks at high prices may face more significant losses if things don't go as expected. 

Are ASX growth stocks a good investment?

Whether growth shares are a good investment depends on your financial circumstances and investing goals. Growth shares are more likely to appeal to investors with a long-term time horizon seeking capital growth. They may be less suitable for income investors, as they often do not pay dividends. 

The share prices of growth stocks can also be volatile, moving as the market mood shifts. This means investors in growth shares need a reasonable tolerance for significant share price moves in the short term. Still, growth shares can prove lucrative over the long term, providing patient investors with big rewards in share price increases.