What do Netflix, Peloton Interactive, Coinbase, and Palantir Technologies have in common? I admit it isn’t a particularly challenging question. As anyone who has been following the U.S. stock market in the last 10 months knows all too well, they are all U.S. large cap growth stocks that have lost more than 50% of their value from their 2021 highs, actually well more than 50%.1 But I’d like to point out that they have something else in common that should be more broadly concerning for investors. They are all growth traps. Growth traps are a subset of the growth universe and get much less attention than their cousins, value traps, despite my attempt to call attention to them in the 2Q 2021 GMO Quarterly Letter, “Dispelling Myths in the Value vs. Growth Debate.” That is a shame, because investors would be well advised to recognize the damage growth traps can do to their portfolios. In honor of the fact that the 10 months since I wrote that Quarterly Letter have seen the largest-ever underperformance of growth traps relative to the overall growth universe, I’d like to offer a quick refresher on growth traps, why they are so painful, and why I believe they are probably going to continue to snap shut painfully on investors’ portfolios for some time yet to come.
My Quarterly Letter last summer defined a trap as a company in either the value or growth universe that both disappointed on revenues in the last 12 months and saw its future revenue forecast decline as well.2 When it occurs to a stock in the value universe, it is a value trap. Judging from the interactions I have had with clients and prospective clients over the last couple of decades, investors seem to believe value traps teem in the portfolios of value managers and that those value traps cause massive damage to those portfolios when they appear. While I would love to tell you that the investors are dead wrong on those presumptions, sadly, they are pretty close to spot on. In a typical year, about 30% of stocks in the MSCI U.S. Value index turn out to be value traps, and they underperform that index by 9% on average.3 But what seems to be somewhat less well known is that growth traps are both more common and more painful than their value brethren, with a prevalence of about 37% of the MSCI U.S. Growth index and an underperformance of 13% on average.4 The underperformance of growth and value traps versus their respective indices is shown in Exhibit 1.
The fact that growth traps are more painful than value traps is, in one sense, not really a surprise. Value stocks are already companies that investors don’t have particularly high hopes for. They trade at lower-than-average multiples by definition. The fact that a company trades at lower-than-average multiples certainly doesn’t mean it can’t fall when its fundamentals disappoint, but it does generally mean that the pain isn’t compounded too severely by falling valuations as well. For a growth stock, however, a disappointment in the performance of the company is extremely likely to result in a falling valuation multiple. After all, these are exactly the companies that the market has awarded higher-than-average multiples because of outsized expectations of their growth prospects. When those prospects deteriorate, valuations almost invariably fall significantly, often precipitously.5
That was certainly the fate of the stocks I mentioned at the start of the piece. And they were by no means alone. While the prevalence of growth traps over the past year has not been particularly noteworthy – 26.1% of the growth universe was a trap over the 12 months ending in April, about 10% below their long-run average – their average underperformance was record-breaking. Over the last 10 months, growth traps underperformed the growth universe by 23%, a worse showing than any 10-month period they experienced, even during the bursting of the internet bubble, and worse than in any 10-month period in the 26 years we have the revenue forecast data necessary to define growth traps to begin with.6 Somewhat entertainingly for those of us managing a value versus growth long/short strategy – in GMO’s case, our Equity Dislocation Strategy7 – we’ve actually found ourselves in recent months buying a handful of our former shorts as they “trapped” all the way across the large gulf from overpriced growth stocks to underpriced value opportunities.8