Growth Traps: A Lesser-Known Risk for Investors

Investors are well aware of the dangers of “value traps” – stocks that may appear cheap but continue to decline in value. However, Ben Inker, co-head of asset allocation at GMO funds, urges investors to acquaint themselves with another risk: “growth traps”. These are stocks that are overvalued and have overly optimistic growth estimates from analysts. When these stocks fail to meet those lofty expectations, they often experience a significant decline.

In his recent paper titled “Value Does Just Fine in Recessions,” Inker delves into the phenomenon of growth traps. While it’s no surprise that recessions typically harm economically sensitive cyclical stocks, causing value stocks to suffer, Inker’s research reveals that growth traps perform even worse. He notes that during recessions, both growth traps and value traps become more prevalent.

Looking back at the past eight recessions, starting from the 1969-70 recession, value stocks, on average, outperformed growth stocks in seven of them. The exception was the most recent recession in 2020, which saw a surge in the stock prices of expensive tech companies.

To understand Inker’s perspective, it is important to grasp his definitions of value and growth. For a company to be classified as a value or growth trap, its revenue over the past 12 months must have been lower than what Wall Street analysts predicted. Additionally, analysts must have revised their estimates downward for the following 12 months. This means that the decline in revenue growth was observed both retrospectively and prospectively – covering a span of two years. On average, approximately 25% of companies fall into the value trap category each year, while 26% are categorized as growth traps. However, during recessions, a larger proportion of companies in both categories fail to meet analyst estimates – reaching as high as 80% among the 1,000 largest U.S. stocks during the challenging 2008 decline.

Typically, highly valued stocks are associated with higher expected revenue growth, which justifies their premium prices. Nevertheless, most growth fund managers define growth not in terms of valuation but by the rate at which a company’s sales and profits are increasing. In certain cases, some companies manage to exhibit both strong growth and reasonable valuations.

Avoiding Growth Traps: The Key to a Successful Investment Strategy

In the fast-paced world of investing, it’s easy for managers to get caught up in the excitement of chasing after the market’s current favorites. However, seasoned professionals understand the importance of a strategy called “growth at a reasonable price.” This approach involves investing in companies that may not be the most popular at the moment, but have proven to be steady performers with consistent growth over time.

One exemplary fund that follows this defensive growth strategy is Jensen Quality Growth (ticker: JENSX). The managers at Jensen have set strict criteria for inclusion in their portfolio. Companies must have achieved a 15% return on equity for each of the past 10 years. This long-term growth hurdle ensures that the selected companies have a history of resilience, even during economic downturns.

In addition to the stringent growth requirement, Jensen also employs a valuation discipline. This means that they steer clear of companies that are overpriced. For instance, despite the popularity surrounding Nvidia (NVDA), a leading artificial-intelligence chip stock with a 233 trailing P/E ratio, it fails to meet Jensen’s 10-year growth test.

Eric Schoenstein, a co-manager at Jensen, cautions against blindly following market momentum. He notes that, historically, the semiconductor sector has been subject to the cyclical nature of the economy. Therefore, consistent growth cannot be taken for granted in this industry. Moreover, competition in the space is fierce.

Despite these factors, Jensen recently made a strategic move by acquiring KLA (KLAC), a semiconductor equipment maker. Schoenstein views KLA as less cyclical due to its “near monopoly” status. With a P/E ratio of 18.8, it presents an attractive investment opportunity.

While Jensen has outperformed during previous downturns, it has lagged behind during significant rallies. For instance, during the 2008 financial crisis, Jensen experienced a decline of 29.0%, compared to the almost 40% drop in popular growth, value, and S&P 500 indexes. Similarly, in 2022, Jensen fell 16.5% while the S&P 500 recorded a loss of 19.5% and large-cap growth indexes dropped nearly 30%.

However, the tide seems to be turning. In the current year, Jensen has shown a notable return of 12.4%, while the Russell 1000 Growth Index has risen by 31.2%. By actively avoiding growth traps, funds like Jensen position themselves to thrive even in the face of an impending recession.

It’s clear that a sound investment strategy focused on long-term growth and valuations is crucial in today’s volatile market. With its disciplined approach and impressive track record, Jensen Quality Growth sets an example for other funds to follow.

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