How to avoid “growth traps”
When high-growth stocks stumble, the market reaction can be brutal. And there’s plenty more to come, says John Stepek.
Most investors have heard the term “value trap”. Indeed, if you’re a value-inclined investor, you’ve probably heard it rather more often than you’d like over the last few years. A value trap is a stock that looks cheap (usually based on a “fundamental” measure such as the price/book ratio) and ripe for a turnaround at any minute, but which simply keeps underperforming. Value traps can do a lot of harm to a portfolio and they are plentiful, says Ben Inker of US asset manager GMO. Inker defines a “trap” as a stock which has missed its revenue expectations in the past 12 months and has also warned on its future sales outlook. In a typical year, nearly a third of the stocks in the MSCI USA value index turn out to be value traps. On average they underperform the index by 9%. So it’s easy to see why the term is so well known. Investors are far less familiar with the idea of a “growth trap”.
A growth trap is just a growth stock (a stock which looks expensive but appears to be growing rapidly enough to justify the premium valuation) which misses its forecasts in the same way. These are, says Inker, even more common and even more damaging than value traps. In any given year, about 37% of the MSCI USA Growth index fall into the category, with an average underperformance of 13%. A good recent example is Snap, which owns social media app Snapchat. Snap saw its share price drop by about 45% in a day last week, after it warned that advertising revenue would be at the lower end of expectations and that the outlook for the wider economy was deteriorating rapidly. The stock is now down about 85% on its 2021 peak.
You can see why “growth traps” are more painful than “value traps”. When a value stock disappoints, it’s just underperforming already low expectations. But when a former growth star disappoints, the gap between the dream and the reality is far greater – so prices have to fall sharply to adjust. Snap is far from the only “growth trap” to have sprung shut in the past year or so. Rising interest rates and the end of the pandemic have made for a particularly tough backdrop for high-flying companies. Streaming service Netflix, crypto exchange Coinbase and fancy exercise bike company Peloton are just some of the casualties.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Yet for those thinking of going bargain hunting, Inker notes that – while they’ve started to lose some of their premium rating – growth stocks remain 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”. In other words, remain wary of expensive stocks that are still pricing in lots of growth – and hang on to your value stocks.
For more on the topic, see:
Value is starting to emerge in the markets
Has growth investing had its day? Don’t be so sure
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
-
Keir Starmer's 100 days in office: chaos and misery
Keir Starmer has achieved 100 days in office. The bumbling and grasping prime minister needs a guiding mission
By Emily Hohler Published
-
Pfizer shares rise as US investor takes $1 billion stake
Pfizer shares are on the up since US activist investor Starboard Value built up a stake in the drug maker. But strategic options appear limited
By Dr Matthew Partridge Published
-
Pfizer shares rise as US investor takes $1 billion stake
Pfizer shares are on the up since US activist investor Starboard Value built up a stake in the drug maker. But strategic options appear limited
By Dr Matthew Partridge Published
-
What is the outlook for oil prices?
Oil prices will be set by the face-off between Saudi Arabia and US shale producers. Could tail risks change the possible outcome?
By Cris Sholto Heaton Published
-
A fairer deal for investment trusts
New rules on how investment trusts report costs should ditch the idea that investors only need to look at one number
By Cris Sholto Heaton Published
-
Top global fintech companies to invest in
One British fintech hogs the headlines, but there are two top performers in the US. We explain where you should put your money
By David C. Stevenson Published
-
Qualcomm could acquire rival Intel – but securing the deal won't be easy
A tie-up between Qualcomm and its semiconductor rival Intel would be a coup. But multiple regulatory and commercial hurdles lie ahead.
By Dr Matthew Partridge Published
-
How Finseta is cashing in on currencies
Finseta has established a foothold in the upper echelons of the market for international payments. Should you invest?
By Dr Mike Tubbs Published
-
Top trusts that offer growth at a discount
Professional investor Alastair Laing picks three trusts where he'd put his money
By Alastair Laing Published
-
How to invest in the quiet market months
Here's how to invest in the quiet market months, since “sell in May” hasn’t paid off this year.
By Cris Sholto Heaton Published