How to avoid “growth traps”

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.

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.

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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.