How the market is severely punishing growth traps
The great expectations laid on companies at the outset of the pandemic have turned into pitiless correction over any weakness
STOCK-PICKERS are used to the concept of “value traps.” Many a stock that looks cheap turns out to be cheap for good reason. Fewer column inches have been devoted to “growth traps” — companies whose growth entices you in, only to disappoint. But that is changing in the month of May.
The month has seen the US stock market mete out immediate and cruel punishment to companies that admit to any problem with growth. After-hours on Wednesday, the chipmaker Nvidia Corp, a part of the NYSE Fang+ index, announced that first-quarter earnings had been better than expected. But the forecast for revenue growth was disappointing. The shares fell almost 7 per cent.
However, Nvidia was lucky. The month has seen a succession of far more drastic reactions to news from companies ranging from retailers (like Walmart Inc and Target Corp), manufacturers (Deere & Co) and social media groups (Snap Inc). In all cases, there was no scandal or big problem to reveal, but rather a disappointing failure to make as much money as hoped. The severity of the response shows that expectations of growth companies are high, and that there is no tolerance for a weakness. Even great companies became growth traps when their growth wasn’t quite strong enough.
It’s important to stress how relatively minor the issues were. Nvidia published earnings for the first quarter that exceeded expectations, but its revenue forecast for the current quarter was disappointing. At one point touted as the next trillion-dollar company, its market cap is now about to breach US$400 billion. Target and Walmart both complained about rising costs that they were not passing on to customers, thus squeezing margins; Deere actually raised forecasts for the full year, but was sold off due to disappointing sales. In all cases, supply chain problems and inflation had made life harder; and in all cases, any sign of difficulty in maintaining sales or margins amid rising inflation was taken as a cue to slash the premium the companies deserved for their growth.
As with many market phenomena at present, it’s possible to view this as the final stage of erasing bizarre distortions specifically caused by the pandemic. Whether you look at the returns attributable to the growth factor, there’s a clear pattern of growth surging in 2020 and giving up much of its gains in the last few months.
In the early months of the pandemic, any company that seemed to have the ability to grow looked exciting. But in many cases, the hopes laid on them have proved excessive. And, it turns out, companies bought for their growth prospects always are more subject to hair-trigger selloffs than value stocks. Ben Inker of GMO, the Boston-based fund management group, defines a “growth trap” as follows in a new paper: “Any growth stock that both disappointed on revenues in the last 12 months and saw its future revenue forecast decline as well.” The same criterion applies to value traps — any value stock that disappoints on recorded revenues and revenue forecasts.
Growth traps tend to create more damage most of the time, compared with other growth stocks. But the gap between growth and value traps has widened sharply this year. Growth stocks that have disappointed have been punished.
That may be in large part because long-term growth forecasts somehow became detached from reality during the heady months of the pandemic-driven boom. Several companies enjoyed a big one-time business boost from Covid-19, and somehow the market seemed to have extrapolated this boost into the indefinite future.
The good news is that most of the excessive hope laid on growth stocks in the last two years has now disappeared. It was a brief but extraordinary victory of hope over experience. The bad news is that prospects for growth stocks are still deemed to be as good as they’ve been at any time in a quarter of a century. At a point when the debate over the macroeconomy swings between inflation and recession or both, that looks unrealistic. It suggests that there are other growth traps out there. It also explains why the market judgment has been so harsh on companies that barely disappointed; the bar of expectations had been set so high that it became impossible to clear.
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