Growth investors who feel safe in the knowledge that they are avoiding value traps should beware that growth traps pose an even greater threat to long-term returns, according to Ben Inker, head of asset allocation at GMO.
Value traps are one of the biggest risks for value managers: when cheap companies turn out to be cheap for a reason and fundamentals end up deteriorating faster than expected.
However, Inker pointed out that companies don’t have to be value stocks to deliver worse-than-expected results.
“It turns out that ‘growth traps’ – companies that are priced for a level of growth that fails to materialize – are an even bigger problem in the growth universe than value traps are in the value universe,” he said.
“If we define growth traps and value traps as companies that both disappoint their revenue expectations and see their revenue expectations come down, we can see they are an ongoing problem for both types of companies.”
Inker pointed out the prevalence of traps in value and growth has been broadly similar over the long term, although there have been periods when there has been more of the latter, such as the run-up to the bursting of the dotcom bubble and the years that followed.
More importantly, he noted that growth traps tend to be more painful for investors – on average, they have underperformed the MSCI US Growth index by 13% a year since 1997, compared with 9.5% for value traps and the MSCI US Value index.
The manager admitted that the growth index has outperformed its value counterpart by about 2% a year over this time, which has hurt the relative performance of the growth traps because they are being compared with a better performing universe. However, he pointed out that growth traps fell 7% a year in absolute terms over this period, compared with 4.8% for value traps.
Inker said this should not come as a surprise.
“Value stocks are, after all, companies that investors do not have a lot of confidence in,” he explained.
“As likely as not, they got to be value stocks because they disappointed investors. Growth stocks, on the other hand, have lofty investor expectations and generally have a history of meeting or exceeding them. When growth stocks fail to measure up to those expectations, it is not a surprise that they are punished severely.”
This raised the question of why ‘value trap’ is a common phrase in investment parlance, while ‘growth trap’ is not.
Inker claimed there were two main reasons. First, when a value manager buys a stock, it is likely to be after it has already disappointed prior investors, so it seems natural to ask why it won’t do so again.
However, his money was on the second reason.
“When a growth manager buys a stock that turns into a growth trap, he/she is very likely to sell it, whereas a value manager might well hold onto a company that has disappointed as long as the price has fallen enough to compensate for the diminished outlook,” the manager said.
“I’m guessing it is the frustration of seeing the same stocks in the portfolio year after year, even after they have disappointed, that is most grating to clients.
“In defence of the value managers who can’t seem to learn from their mistakes, the autocorrelation of these disappointments is very low.
“The fact that a stock was a value trap in one period has more or less no bearing on whether it will be one in the next period.”
He pointed to a graph showing that the probability of a stock being a value trap in any given year is about 30%, which is true regardless of whether or not it had earned the distinction in the prior period.
On average, 9% of the stocks in a value manager’s portfolio will have disappointed two years running, and 3% for three years running.
“One can easily imagine the frustration in seeing such stocks sitting in a portfolio that had cost them money for years,” he continued.
“It is harder to imagine such stocks existing in a growth portfolio. But here is the basic issue. It really does make sense for a growth manager to sell stocks that have significantly disappointed. Such companies are legitimately less growthy than the managers were hoping they would be, and they are a less good fit in a growth-oriented portfolio.
“A value stock does not become less of an obvious fit for a value manager just because it has disappointed. Remember, most value stocks got to be value stocks because they disappointed investors somewhere along the line, after all.
“But just because growth managers sell their disappointments, it doesn’t mean those growth traps didn’t cost them money. On average, growth traps almost certainly cost the growth managers even more, it’s just that most of them are ‘new’ traps instead of old ones.”
Inker accepted that many modern investors are unlikely to be persuaded by his argument and will cling on to the growth style that has served them so well over the past decade. In this context, he said that the growth rally over summer may seem like a return to the “normal” pattern after a couple of quarters of a value surge.
“We, like almost everyone, are social creatures who want to fit in and join the party,” he continued.
“But we’re also patient, valuation-sensitive investors who have seen this story before. While companies and markets evolve (as do our equilibrium assumptions about the proper discount at which value should trade relative to growth), the valuation disconnect between value and growth has reached extreme levels today.
“We’ve heard many reasons why ‘it’s different this time’ and growth is destined and deserving to outperform.
“At these relative valuation levels, our long-term bet is the opposite,” he finished.