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.

Silhouette holding a smartphone with the Snapchat logo
Snap is down about 85% from its peak
(Image credit: © Rafael Henrique/SOPA Images/LightRocket via Getty Images)

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.

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John Stepek

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.