There has been an interesting shift in the market over the past several weeks, as high-growth stocks (an area to which we have limited exposure, given our preference for more fairly-valued growth opportunities) have suffered a significant correction after being the darlings of the market since June of last year. By “high-growth,” we mean companies that are highly valued and growing their revenue at high rates. According to Empirical Research Partners, from June 2013 into March 2014, this “big-grower” segment of the market outperformed the S&P 500 by about 20 percentage points. The S&P returned about 15% over this period, so this group saw their value rise by over a third in a nine-month period. For about four weeks starting in mid-March this out-performance sharply reversed, as the group dropped significantly more than the market. Why did this happen?
Before we try to answer that let’s look at the composition of this group of stocks. These companies have been growing sales at a rate of about 30% on average – an impressive figure, especially in today’s low-growth environment – and certain industries are well represented, including biotech, social media and cloud computing. Most of these companies not only have strong growth rates but attractive stories to match. Mix in an economic environment where growth is scarce and you have the perfect recipe for their rising valuations. In fact, after the run these high-growth issues had, they were priced at a premium that had been exceeded only three times since 1952: the Nifty Fifty era of the 1970s, the early 1980s energy boom, and the New Economy era of the late 1990s. Of course each of these eras was accompanied by great stories – and poor subsequent returns for the high-growth stocks swept up in the mania. To be fair, the premium valuations that prevailed in these prior periods exceeded what existed in mid-March, in some cases dramatically, but the fourth-highest relative valuation in over 60 years was certainly a warning sign.
Another warning sign was the fact that the companies within this high-growth group, even if they were in completely un-related businesses, were often trading in a similar fashion on a day-to-day basis. The correlation among the stocks was near the high end of its long-term range. For example, the daily moves in Facebook stock were similar to those in biotech stocks. This indicated that much of what was happening was a macro phenomenon, more so than a collection of unusually appealing individual growth stories.
But what sparked the sudden correction? We think the most sensible answer to this question is that the economic data improved. This may sound counterintuitive (Wouldn’t high-growth stocks benefit from an improving economy?), but remember we are talking about relative attractiveness. If economic growth is picking up speed, more boats will be lifted, thereby reducing the premium that investors are willing to pay for companies with elite growth. Another possible contributor is the fact that the Federal Reserve signaled that it may raise interest rates sooner than expected. This will potentially have the effect of increasing the discount rate of future cash flows, which disproportionately affects (negatively) high-growth issues. Perhaps a more realistic effect of the Fed’s signal is that it represents a reduction in the liquidity that has been helping to drive these stocks higher.
These factors started the snowball, and then the decline was likely exacerbated by the fact that many of these stocks were, as they say on Wall Street, a crowded trade. Just as rising prices had begat buying on the way up, falling prices now prompted more selling on the way down, most prominently among hedge funds.
How much farther will these stocks fall? Empirical tells us that the group has given back about half of its multiple expansion and that prior incidents of big growers giving back a significant chunk of their appreciation tended to foreshadow further underperformance. Things could certainly work out differently this time, and in recent days the stocks have had a nice bounce, but the odds appear unfavorable. Performance may come down to how strong the economy is, with an accelerating economy leading to further underperformance.
Our portfolios hold positions in a couple stocks that fall into the high-growth category, such as Google and Amazon, but we have largely avoided the group, and we certainly have less exposure than do other growth managers. The reason for this, aside from the recent elevated valuation of the group, is that high-growth companies tend to make poor investments. (It’s understandable if you are scratching your head right now.) It is very difficult for a company to maintain a high rate of growth, and yet many are priced as if they will. When growth ends up being less than expected, as often happens, the company’s stock is revalued downward, even if that growth is better than at most companies. The fact that high-growth stocks tend to garner such high valuations and continue to underperform as a group over the long-term is an example of the triumph of hope over experience. The historical data shows that, on average, relative to other stocks, these are poor investments.
But, as in Greek mythology, it is difficult to resist the Sirens (in this case the appealing growth stories), and most investors would be better off tying themselves to the mast, as Odysseus did. That said, it is possible to successfully cherry-pick among this high-priced group, as there are indeed companies that buck the trend. But, given the unfavorable odds, it seems prudent to limit our forays into such treacherous waters and instead focus on reasonably valued, less-hyped growth opportunities, as we try to do.
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A few weeks ago author Michael Lewis told 60 Minutes that the stock market was rigged due to high-frequency trading (HFT), which is the use of computers that read the market for an individual security and rapidly make trades to profit from this information. It is essentially “skimming” or “front-running,” and while unethical it is not illegal. Oak does not participate in such strategies, nor do the vast majority of money managers. But this segment of the market now represents about half of all stock trading. We have mixed emotions about Lewis bringing this issue to the forefront. On the one hand, the exposure will likely lead to measures that either eradicate or seriously hinder this practice, which is good. On the other hand, the pronouncement that the stock market is “rigged,” while effectively drawing attention to the issue and generating book sales, will also scare away some investors from what remains the best way to grow one’s wealth: stocks. HFT operates on fractions of a penny, so when you buy a stock or your mutual fund buys a stock, instead of paying $35.50 per share you or the fund may end up paying $35.51, because the high-frequency traders have skimmed that penny by buying at $35.50 and immediately selling it to you or your fund at $35.51. This may be irritating and unfair, but in the grand scheme of things it is inconsequential to your long-term return. The potentially tragic outcome of Lewis’s proclamation is that many thousands of people who are already skittish about stocks due to the memories of past market corrections may hear “rigged” and think this is further confirmation that they should stay away. As a result, the long-term rate of return on their investment portfolios will almost certainly be much lower than it would be if it included stocks. Lewis is a terrific author with a good heart, but his contention that the market is rigged is reckless.
Best regards,
Mark Oelschlager, CFA
Portfolio Manager
Oak Associates, ltd.
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