One of the biggest mistakes many investors make is extrapolating the past to predict the future. Another, is not taking account of what is already priced in, writes JP Morgan’s Mike Bell.
It can be tempting, when trying to work out what a company will earn in the future, to look at how fast it has grown in the past and then assume it will carry on growing at that pace. However, to highlight the dangers of this approach, let’s consider my nearly two-year-old daughter, who’s obviously grown very quickly since she was born. If I were to extrapolate her growth rate, I’d assume that she’ll be a giant. If you’ve ever met me in person, you’ll know that’s very unlikely.
The same is true for most companies. Early on in their life, or in the life of a new product of theirs, they may experience strong growth. However, while that rapid growth may continue for several years, it tends to slow down the bigger the company gets and tends not to last forever.
What’s more, like some teenagers, during the pandemic some companies experienced a growth spurt, as governments handed out lots of money and everyone was forced to stay at home. Online advertising and shopping, home interiors, particularly office and gym equipment, TV streaming, food delivery and virtual communication services all boomed.
Extrapolating that into the future was clearly dangerous thinking. Not only as the pandemic-related growth fades but also as the cost of food and energy surges and households are forced to cut back on non-essential spending.
Some governments might also not help out as much during the next recession because of fears about fuelling inflation or other political constraints. So, stocks that proved defensive during the last recession might not be this time around.
Profit not always a sign of value
Another big mistake is not taking account of what’s already priced in. Firstly, investors sometimes overvalue fast growing but unprofitable companies. However, making a profit, even a very large one, doesn’t mean a business can’t also be overvalued.
Second, of course fast-growing profitable businesses are more attractive than slow growing profitable businesses if they trade at the same valuation. But being a fast-growing company doesn’t mean it’s a great investment if that’s already factored into the valuation.
For example, about a year ago, I started to learn how to play golf. It’s a very frustrating game and I’m still awful. But the joy of golf is that there is a handicap system. It’s designed to let players of all abilities enjoy playing together by adjusting the scores by a predetermined number of shots when calculating who won.
With a large enough handicap, a bad golfer could win against a good golfer, once the scores were adjusted. It’s the same for companies. Think of a cheap company as having a high golf handicap and an expensive one as having a very low handicap. The expensive company may be a better company, but it won’t necessarily be the better investment.
Significant growth stock underperformance
That’s not to say that there are no fast-growing companies that are attractive investments, but investors need to be selective. They should first filter down to the companies that can genuinely continue to deliver strong growth long into the future and then filter out those where that is already priced in.
At the start of this year the Russell 1000 growth index traded on a price to earnings ratio of 31. After the sell off so far this year, that’s down to 23 at the end of August. Less expensive but still not cheap when you consider that in 2008 growth stocks traded as low as 10 times earnings.
As at the end of August, the Russell 1000 value index trades at under 14 times earnings. So, the difference between the valuation on growth and value stocks is still twice as wide as its average since 2003, despite growth stocks’ already significant underperformance so far this year.
So overall, I think it makes sense to be selective within growth stocks and to balance them in the equity part of a portfolio with stocks where the valuations are already pricing in a significant amount of bad news.
Some value stocks are already pricing in a high probability of a recession. In addition, government bonds are not yet pricing in the degree of rate cuts that tends to accompany a recession and, so along with defensive alternatives like infrastructure, could provide some ballast to portfolios if the global economy continues to cool.
This article was written for Portfolio Adviser by Mike Bell, executive director, global market strategist at JP Morgan.
