Is it time to pick up growth stock bargains yet?

Growth stocks have had a tough time this year.

Indeed, they’ve had such a tough time that some of you might be getting twitchy trigger fingers.

You might be thinking: “Hmm. Some of these growth funds are down by more than 50%. Should I be investing?”

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I’m going to cut to the chase: I think it’s too early. There are still plenty of “growth traps” out there.

Why growth traps are more painful than value traps

What’s a “growth trap”?

Ben Inker of GMO (a US asset manager which is strongly identified with value investing) defines both growth and value traps as stocks which have disappointed on revenues in the previous year, and have also seen their future revenue forecasts fall.

As Inker points out, “value traps” are more commonly known. A stock gets called a value trap because although it looks cheap, it’s only going to get cheaper. This apparent cheapness attracts bargain-hunting investors, who then get burned, because the turnaround they believe must “surely” be around the corner doesn’t end up happening.

But “growth traps” exist too. And – surprisingly – they’re “both more common and more painful than their value brethren”, says Inker.

We’ve just seen a good example. This week, social media website Snap saw its share price drop by more than 40% in a single day after it warned that advertising revenue would be at the lower end of expectations and that the macro environment was rapidly turning grim.

The stock is now down about 85% on its September 2021 peak.

So what’s going on? We’ve said before here that the market is now “short dreams, long reality”. Warren Buffett has suggested that interest rates are “like gravity” for valuations. If rates are low, valuations can soar; if rates are high, “that’s a huge gravitational pull on values”.

That makes for a tougher backdrop for growth stocks than for value stocks. Put very simply, value investors buy value stocks because they look cheap compared to their judgement of their “intrinsic value” today. Value investing is usually based on some fundamental ratio – like price/book, or price/earnings – being low compared to where the investor thinks it should be.

The investor might be wrong (hence the “value traps”). But their argument is generally predicated on markets being overly pessimistic about the present, let alone the near future.

Growth stocks, on the other hand, are bought based on expectations. The basic argument that a growth investor will make is that the stock might look expensive today, based on fuddy-duddy fundamental ratios. But the fundamentalists are neglecting the fact that the company is seeing exponential growth, or that rising revenues can be converted to huge profits and a sustainable moat at some point in the future.

In other words, growth stocks are bought based on markets being insufficiently optimistic about prospects for the more distant future.

What happens when the traps spring shut?

You can start to see why “growth traps” are more painful than “value traps”. When a value stock disappoints, it’s just adding insult to injury. An already poor performer still somehow managed to under-deliver. There just isn’t that far to fall.

But when a growth star disappoints, the gap between the vision and reality is brutal. The investor has been anticipating a castle in the sky; instead they get a bungalow on wobbly-looking stilts.

Now, both styles have their times in the sun. As an investor, I have a value bias, but that’s a flaw I recognise – it’s not a badge of honour. (You have biases too, by the way – it’s better to be aware of them and try to correct for that rather than pretend that you don’t.)

However, it’s also fair to say that growth has had a very long time in the sun, which is one reason why the current shakeout is proving so brutal.

The question now is: are we any closer to this being over? On that front, the answer appears to be “no”. Inker points out that, while they’ve started to lose some of their premium rating, growth stocks are still very expensive relative to value stocks compared to history. That in turn implies, he says, that we can expect to see more “growth trap” collapses “in the next year than there were in the last one”.

The other point that’s interesting to me – and not one taken up by Inker in his paper – is that a lot of this is simply blowing away the Covid-era froth.

If you believe, as I do, that the backdrop was changing even before Covid came along – ie, that inflationary pressures were shifting, and that Covid just added to this, rather than being the key driver of it – then simply going back to pre-Covid share prices is not enough. Growth stocks have to fall further to take into account the new and more hostile world that we’re emerging into.

We’ll see what happens. But for now I’m still wary of thinking there are bargains in the growth rubble here. Although my colleague Matthew does have some thoughts on stocks to watch in the latest issue of MoneyWeek magazine. It’s out tomorrow - but if you don’t already subscribe, get your first six issues free here.

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