Many investors are familiar with “value traps” – stocks that appear cheap but lack fundamental value. However, according to Ben Inker, co-head of asset allocation at GMO funds, it’s equally important to be aware of “growth traps” – overvalued stocks that have unrealistic growth estimates from analysts. When these stocks fail to meet the inflated expectations, the consequences can be severe.
In a recent paper titled “Value Does Just Fine in Recessions,” Inker delves into the phenomenon of growth traps. While recessions typically have a negative impact on economically sensitive cyclical or value stocks, growth traps suffer even more. Inker’s research reveals that recessions increase the prevalence of both growth and value traps.
Historical data supports the claim that value stocks tend to outperform growth stocks during economic downturns. In seven out of the past eight recessions spanning from the 1969-70 downturn, value stocks emerged as winners. The only exception was the most recent recession in 2020, when expensive tech stocks surged.
To define value and growth traps, Inker focuses on a specific criterion. A company is classified as a trap if its revenue over the past 12 months falls below the consensus estimates of Wall Street analysts. Furthermore, these same analysts must also revise their estimates downward for the upcoming 12 months. This dual perspective ensures that the assessment of revenue growth includes both backward and forward-looking considerations, covering a two-year period. On average, approximately 25% of companies fall into the value trap category each year, while around 26% fall into the growth trap category. However, during recessions, a significantly higher percentage of companies in both categories fail to meet analyst estimates. In fact, during the 2008 market decline, approximately 80% of the top 1,000 stocks in the United States were considered growth or value traps.
It is worth noting that highly valued stocks typically come with higher expectations for revenue growth. This explains why investors are willing to pay a premium for them. However, many growth fund managers define growth not solely based on valuation but rather by the speed at which a company’s sales and profits are increasing. In some cases, companies can demonstrate both strong growth and modest valuations.
Avoiding Growth Traps: A Strategy for Success
Managers can navigate the pitfalls of growth investing by adopting a strategy known as “growth at a reasonable price,” according to Inker. Instead of blindly chasing the market’s current favorites, these managers, referred to as GARP managers, focus on investing in undervalued and stable companies that exhibit consistent growth over time.
Jensen Quality Growth (ticker: JENSX) is a prime example of a defensive growth fund that follows this approach. The fund’s managers have stringent criteria for portfolio inclusion, requiring companies to maintain a minimum 15% return on equity over the past decade. This strict long-term growth benchmark ensures that portfolio companies have demonstrated resilience even during challenging economic conditions.
Furthermore, Jensen adheres to a valuation discipline that steers clear of overpriced companies. For instance, despite the popularity of artificial-intelligence chip stock Nvidia (NVDA) in 2023, which boasts a trailing P/E ratio of 233, it fails to meet Jensen’s 10-year growth test.
The fund’s co-manager, Eric Schoenstein, highlights that blindly following market momentum can be detrimental, especially when it shifts in the opposite direction. He emphasizes that the semiconductor sector, which Nvidia operates in, has historically been cyclical and susceptible to economic fluctuations. Therefore, consistent growth cannot be taken for granted within this industry due to fierce competition and changing market dynamics.
Interestingly, Schoenstein recently made a purchase in the semiconductor equipment sector with KLA (KLAC). This investment is considered less cyclical due to KLA’s “near monopoly” position, and its relatively low P/E ratio of 18.8 adds to its appeal.
While Jensen has outperformed during previous downturns, it has lagged behind during significant market rallies. For example, during the 2008 financial crisis, Jensen experienced a decline of 29.0%, while popular growth, value, and the S&P 500 indexes dropped almost 40%. Similarly, in 2022, Jensen fell 16.5%, whereas the S&P 500 lost 19.5%, and large-cap growth indexes declined by nearly 30%.
However, in the current year, Jensen has achieved a commendable return of 12.4%, while the Russell 1000 Growth Index has surged by 31.2%.
By diligently avoiding growth traps, funds like Jensen will likely emerge as winners in the next economic downturn.
