Cuffelinks Article | The market loves growth stocks – until it doesn’t

Words by Robert Miller Portfolio Manager NAOS Asset Management

In light of the recent misfortunes suffered by high-profile ASX growth stocks (Bellamy’s, Estia Health, and iSentia Group to name a few), it’s worthwhile seeing if there are any obvious lessons investors can take into 2017.

Growth stocks by their nature tell a story that provides some justification of their future earnings potential. These stocks can dazzle as their futures unfold, but it’s important to remember the other side of the trade when things don’t go as planned.

High profile growth stocks volatile

Firstly, from a risk perspective, investors benefit from knowing how a growth stock will compare with the wider market. Beta is the measure of the volatility of a security versus the market. It can provide an indication of how volatile or ‘wild’ the ride might be, from both positive and negative sides. For example, if growth Company A has a market beta of 1.5 it is likely to be 50% more volatile than the market. That is, if the market goes up 1% then Company A should rise 1.5% and if the market falls by 1% Company A should fall by 1.5%.

Secondly, the cliché ‘up the stairs down the elevator’ is particularly relevant when looking at growth stocks. Put simply, a company is more likely to go from overvalued to undervalued far more quickly than from undervalued to overvalued. Growth stocks are either undervalued or overvalued but rarely fairly valued. We know the higher the price the higher the risk, yet our FOMO (fear of missing out) may cause us to jump into a growth stock, chasing and in fact promoting the ‘paper profits’ seen by the earlier investors.

On the flip side, our apprehension may cause us to sell out at a large and sudden discount even though the risks of the business are provided at a large discount.

Market has a short memory

If you ask the question (assuming business fundamentals remain), that if I was happy to buy stock at a 30% discounted price on the way up, shouldn’t I be considering buying it now?

The market tends to have a short memory and is always willing to be swept away by the next big growth stock. If we take a look back to calendar year 2015, the top 10 performers in the All Ordinaries Index produced an average return of approximately 400% (if you exclude resource companies, the top 10 performers returned an average of approximately 275%). Leading the charge were the market darlings, Bellamy’s and Blackmores, which had P/Es of 140 and 80 respectively during that time. The market is forward looking to a current P/E on a growth stock so it will invariably look high, but these figures also provide a sense of relativity to the general market P/E range of 15-17.

If we look at those same performing stocks in calendar year 2016 (so far), the return of the non-resource top 10 market darlings from 2015 is -18%, excluding one which has gone into liquidation. Of those which have produced negative returns, the average is -35%. A company reinvesting for growth often means you don’t have a dividend yield to soften the loss, and an investor that arrives late to the party can end up with negative returns quickly.

Here are four lessons to keep in mind before investing in growth stocks:

1. have a price level of where you think the stock is either undervalued or overvalued and write it down so you don’t forget
2. don’t ignore a company’s beta – the higher the beta, the higher the risk of a larger pullback
3. chasing someone else’s paper profit is not a sound investment decision
4. if you’re caught up in a large correction, take your time to weigh the options in the context of undervalued vs overvalued. Has the bubble burst or is this an opportunity to buy at a price you could only have dreamed of a few days ago?

Robert Miller is a Portfolio Manager at NAOS Asset Management. NAOS runs two LICs, ASX:NCC and ASX:NAC. This article is general information and does not consider the circumstances or investment needs of any individual.

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