Value & Growth Traps

A value stock, in the traditional sense of the word, is typically a company that screens well on traditional value metrics like low P/B, P/E, P/FCF, high dividend yield and other “value” ratios. A growth company screens well on quality metrics like high ROIC, operating margin, revenue growth, low leverage etc. For value stocks, the metrics are tracking how cheap the company is whereas for growth stocks, the metrics are tracking the strength/quality of its financials. Whenever you make a judgement to buy a stock, it is usually because you believe it is selling at a below average price (value stock) or above average quality (growth stock). Some stocks fall into both buckets but let us ignore that for now.

So, you have a broad test for identifying value and growth stocks. However, your judgment can be flawed. More precisely, it can be flawed in two distinct ways – through false positives and false negatives.

Imagine you are feeling unwell and you go to your doctor for a blood test to see if you have some rare disease. You have a matrix of four possible outcomes. A positive result that is correct (a true positive), a negative result that is correct (a true negative), a negative result that is wrong (false negative) and a positive result that is wrong (false positive). True positives and true negatives are not a problem. The danger lies in false positives and false negatives i.e. the misdiagnosis.

Now, which is worse for a potentially fatal but curable disease – a false positive or a false negative? A false negative is infinitely worse. Why? Because a false negative says you don’t have the disease when you actually do. In medicine, false negatives can be fatal while false positives can be an inconvenience.

For an email spam filter on the other hand, false positives are infinitely worse than false negatives. A spam email incorrectly classified as not spam (false negative) is an inconvenience. A real email misclassified as spam (false positive) is potentially lost business or an angry friend who didn’t get a response.

Value and growth traps are essentially false positives – misclassified value and growth stocks. A classic example of a value trap is a company selling at a deep discount to its liquidation value (tangible book value or net current asset value) with a low P/E, high dividend yield etc. The entire industry may be depressed so the asset values are probably overstated and would fetch less than what is stated on the balance sheet in a liquidation. Also, if the company is shrinking i.e. revenue growth below inflation and/or negative operating cash flows then the margin of safety is slowly disappearing. Time is not on the side of a value trap. So how do you quickly lose money in a value trap? The valuation multiples contract even further, or the company’s financials continue to worsen. Since the company is already so cheap, the latter is usually more likely.

How do you lose money in a growth trap? Valuation multiples contract and/or increased competition from other companies reduces ROIC. This has happened, in a big way, twice in recent financial history – during the 1970s with the Nifty 50 stocks and the dot com bubble. The Figure below shows the P/E ratios and subsequent 10 years annualised returns of some Nifty Fifty stocks in 1972.

All of these companies still exist today and are significantly bigger than they were back then. However, because they were trading at very expensive prices, investors buying shares in 1972 made very mediocre returns for the next 10 years. Imagine buying shares in McDonalds, a rapidly growing fast food chain in 1972 and making only 1.8% annualised for the next 10 years. Not many investors would have had the patience to hold on. This also happened with Microsoft and Amazon during the dot com bubble. However, over the long term (15+ years) all of these growth companies did very well.

The enemy of the growth investor is multiple contraction in the short term and the entrance of new competition in the long term. The latter is much worse than the former because new competition can drive multiple contraction. How? Through price wars. Capitalism generally works and a company with a high return on invested capital (ROIC) attracts competitors.

So how do you spot value and growth traps? This is where judgement is important. Screening for “value” and “growth” or “quality” stocks is relatively easy. However, you want to avoid the false positives. These are the value and growth traps that cost investors a lot of money.

For “value” type stocks i.e. very low P/E, high FCF yield, stocks selling below net current asset value etc, a simple way to reduce the false positive rate i.e. number of value traps, is to avoid any company that has consistently lost money in the past. By “lost money” I mean negative free cash flows. You will miss out on some potentially big winners doing this (i.e. the false negatives) but you will, in aggregate, avoid more false positives.

For “growth” or “quality” type stocks, the best screen is a company with a high ROIC. However, ROIC can be fickle and generate a lot of false positives. To reduce the number of “growth” traps, you need to find companies that have a consistently high ROIC through the market cycle. What qualifies as a “high” ROIC? I would say an ROIC greater than 15% is a start. By simply investing in companies with some consistency in ROIC through a 7-10-year period, you will reduce the false positive rate i.e. the frequency of growth traps.

But alas, this is not enough. A high historical ROIC is not indicative of a high ROIC in the future. A misguided faith in quantitative screening can be harmful. Thales, the Greek philosopher, was so intent on counting the starts that he kept falling into potholes on the road. You need to have very good judgement in order to reduce number of growth traps. How can this be done? Well for a start, you need to understand why that company has a high ROIC so you can have some measure of predictability about its future. Is the company a low cost producer? Does it have a great brand? Network effects? Essentially, what exactly allowed the company to have a high ROIC in the past?

Avoiding value and growth traps requires good judgement. It is easy to build a screen searching for low priced or quality, fast growing companies. It is much harder to reduce the false positive rate which will reduce the number of value and growth traps you invest in. In the long run (15+ years) overpaying for a growth stock may actually not be harmful to your returns. This happened with all of the companies highlighted in the Figure above. However, there were other stocks in the Nifty Fifty era that do not exist anymore. These are the “growth” traps and they cost investors a lot of money. A notable example is Polaroid.

The Table below shows the longer term returns from some of the Nifty Fifty stocks (courtesy of FTAlphaville)

Over 20 years, you did not lose any money investing in these stocks. Over 30 years, the cheaper stocks performed just as well as the more expensive ones. This is because over longer periods of time, the return you get from a stock will be roughly equal to its ROE. There may be some multiple contraction that will cause your actual return to be lower than the stocks ROE but you get the point.

Herein lies the trouble with overpaying for stocks, no matter how quality they are or how rapid their growth. Do you have the mental fortitude to do nothing or even add to you position after 10 years of poor or negative returns? A few investors think they do but many in fact don’t. This is the real risk in paying up for growth companies. Over the long term, you will do fine. Not exceptionally well, but fine. You will certainly outperform the broader market. The S&P 500 has annualised about 10% nominal returns (dividends reinvested) over the last 40 or so years. Same with the MSCI UK index. Most of the Nifty Fifty stocks had higher returns over a similar timeframe of 40 years. The two factors that will hurt you the most when investing in high quality/growth companies is that your measure of “quality” may have a high false positive rate thereby increasing the amount of growth traps and no patience to hold the stock when they are down or flat over a 10 year period.

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