growth stocks

Growth stock investors are dreamers.  They try to find stocks that will grow faster than the consensus expects, for longer than the consensus expects.

As a good growth stock reports surprisingly good earnings results, the stock price typically rises.  Two causes:

–the stock adjusts up for the better earnings; and

–expectations for future growth rise, leading to price earnings multiple expansion.

If, for example, the stock is trading at 15x expected year-ahead earnings before the report, after the report it may end up trading at 18x the new, higher, level of expected earnings.

At some point, this explosive upward force becomes spent.  The reason may be technological change, or maybe new competition, or maybe the market for the company’s products is completely saturated  (a fuller discussion).  As this happens, the supercharged upward path I’ve just described begins to go into reverse.  The company reports disappointing earnings.  The stock moves downward to reflect new, lower, earnings expectations, and the price earnings multiple contracts.

Today’s question:  how/when does this negative process stop?

It’s important to realize that professional growth stock investors have seen this movie of mayhem and destruction many times before.  They know the plot lines well.  There may initially be some doubt about exactly when the downturn is commencing.  But growth investors know that how they sell a stock is the most crucial determinant of their long-term performance.  So once they become convinced that the salad days are done, they’ll be quick to sell.

The initial buyers will likely be non-professionals who see a decline as a chance to buy a stock they’ve heard about from the financial press or from friends and which appears on the surface to be less expensive than it previously was.   Or they may be members of the growing class of professional traders, many of them associated with hedge funds, who are not particularly interested in company fundamentals, but who buy and sell for short-term profits, either “reading” stock price charts or using their “feel” for the rhythms of the markets to make their decisions.  Eventually both groups also figure out the bloom is off the rose.  In my experience, the traders sell to cut their losses; the non-professionals continue to hang on.

The eventual home for former high-fliers is with value investors, who specialize in companies with flaws where the stock has been beaten down in an excess of negative emotion.  Typically, value investors use computer screens to identify the lowest, say, quintile of the market measured by price/cash flow or price/book value.  That will be the universe they study more closely to make their stock selections.  Many times, these stocks will be in highly business cycle-sensitive industries,  or ones that show little growth.  Companies may be laggards in their industries, either because of poor management or other fixable problems.  Value investors typically say that they buy $1 worth of assets/earnings for $.30 and sell it at $.80.

The point is it usually takes a long period of time, and enormous deterioration of a growth stock’s fundamentals, before the fallen angel sinks low enough to catch the value stock investor’s attention.  Also, like their growth stock counterparts, value investors have industries that they have studied carefully for years and which constitute their comfort zone.  The two areas of familiarity are pretty close to mutually exclusive.  So it may take an extremely cheap price for a value investor to take the risk of buying, say, a tech company instead of a presumably safer–or at least better understood–cement plant, auto parts maker or steel mill.

As I’ve written many times before, the one exception to this pattern that I’ve seen is AAPL, whose price earnings deterioration began five years or more ago (depending on how you count) despite continuing explosive earnings gains.  In fact, at present, AAPL shares are trading at a 25% discount to the market median PE multiple, according to Value Line.  True, there are qualitative signs that AAPL’s growth heyday may already be in the rear view mirror.  But the market’s bad treatment of the stock seems excessive to me.  Price action after the upcoming earnings report will be instructive.