NZX-listed growth stocks have offered investors big capital gains in recent years but with high growth comes a high level of risk.
The recent performance of cloud-based accounting firm Xero, New Zealand's best performing growth stock, highlighted the risk of investing in such companies.
Xero's share price had risen by more than 200 per cent in the past year but over the last few weeks dropped sharply from a peak of $45 to $29 at the end of last week.
Such volatility was part and parcel of investing in growth stocks and investors hedging their bets on the next big thing should be well aware of the risks, analysts warned.
AMP Capital head of investment strategy Keith Poore said historically, New Zealanders were more inclined to invest in high yield, defensive stocks but those habits were changing.
Many investors were left scarred after the 1987 stock market crash and when the dotcom bubble burst in the late 1990s.
"Those scars were pretty deep and I think we're starting to shake those off a bit and looking for more opportunities in other stocks and that's good for the market and the economy as a whole."
Growth stocks typically had earnings or revenue growth which rose faster than the rest of the market, he said.
The key for investors was to build a portfolio with a good balance of defensive and growth stocks to withstand a variety of market conditions, he said.
Hamilton Hindin Greene director Grant Williamson said IT stocks could be particularly difficult to analyse.
"We felt there has been a little bit too much hype in these companies in the last few months."
Some investors were still doing very well out of such companies as Xero but the market could change quickly, he said.
"When the tide does turn a lot of investors want to hop out at the same time."
After a couple of good years on price movements some of the stocks appeared to be coming under profit taking pressure.
"Investors are told: ‘Don't follow the crowd or you'll end up losing money,' and unfortunately we have seen a little bit of that."
Authorised financial adviser Martin Hawes said many older investors were too dividend-focused and were limiting their investment strategy by not considering growth stocks.
"You're far better to look at total returns - that is both capital growth and income," Hawes said.
One dollar of profit from capital gains was just as good if not better than one dollar of income profit because capital gains were not taxed, he said.
But Hawes was cautious of IT stocks because they were too difficult to understand and put a value on.
People who did invest in specialised high-growth stocks either had little risk aversion or a good understanding of the company or the sector, he said.
There were companies in the retirement sector with good growth prospects, he said.
"I wouldn't be shunning those companies just because their dividends are small. They are relatively easy to get your head around and they tend to be well researched."
Craigs Investment Partners head of investment management James Beale said the right time to buy growth stocks was before the rest of the market recognised the opportunity.
"The very early stages of a growth rally almost come whilst people are still a little concerned about the outlook."
New Zealand had passed that stage of the recovery cycle and growth stocks had performed well, he said.
As interest rates rose investors tended to switch from yield orientated stocks such as utilities, property and consumer staples to higher performing stocks such as industrials, financials, materials and energy stocks, he said.
These performed better and grew profitability when economic activity increased.
New Zealand traditionally had a large proportion of defensive, income-focused stocks, which provided good income flows but that ratio was now changing with a number of new IT company listings, he said.
Craigs Investment Partners was advising investors to look overseas to use the strength of the New Zealand currency to buy growth stocks.
It saw opportunities in such United States growth stocks as General Electric, United Technologies and Visa, which performed well with increased consumer spending.
Growth stock returns did not necessarily all come from capital growth but in the short term, investors should expect a lower return from dividends.
"That's sort of the tradeoff with growth stocks."
Investors looking at growth stocks overseas should seek good access to the market, good research and be prepared for higher transaction costs, he said. They should also be aware of exposure to currency risk.
Forsyth Barr head of private wealth research Rob Mercer said the price of growth stocks could be difficult to justify at times.
"In many respects the valuations are outpacing what analysts can rationally justify.
"In the future we will find out which ones actually deliver the performances that are needed to support that."
The main thing to consider was growth at a reasonable price (GARP), he said.
Some investors got caught up in the hype of a growth stock and "could get a bit frothy" about its prospects.
"There needs to be a really solid base of profitability to support valuation. You need some financial metrics to support the investment case."
- Fairfax Media