One thing stock markets are extremely good at is storytelling. Every bubble, every shift in market sentiment, comes with a good yarn. You could even characterise a market as a story competition – the best one gets to provide the framework for the winning investment strategy.
Look closely at the market and you will see that whatever people say about stock market analysis being driven by models and maths isn’t quite true. We were hearing the story of bitcoin – how cryptocurrencies will save us in an age of government over-reach and fiat money meltdown – long before the models comparing its market capitalisation to that of gold appeared to justify a forecast price of $500,000.
The same is true of ESG investing (that which has an eye to environmental, social and governance issues). The story goes that if fund managers would only step up and focus on non-monetary issues, we could avoid another financial crisis and all make more money too. The problem with this narrative is that for years it had no real statistical basis – before, that is, the growth bubble gave it some happy numbers to work with largely because most stocks that fit ESG models are also growth stocks.
The same is true of the growth boom itself. Stories tend to come before the models that back them up. I think market participants all know this to be true. But turn to Nature magazine and you get a hint of how it might be the case across many professions. The journal cites a recent academic paper studying theories about the connection between consciousness and neural activity (which are more relevant to markets than you might think, by the way). The paper’s authors observe that most studies “interpret their findings post hoc, rather than a priori testing critical predictions of the theories”. In other words: stories come first.
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This is unfortunate in markets (fun, of course, but unfortunate) because, unconstrained by the absolutism of a models-first environment, we tend to take things to extremes and to extrapolate our stories to the point at which they become nonsensical. And so it has been with the great growth boom over the past decade.
The story started well with the recognition that the growth potential in technology, in particular, was undervalued following the financial crisis of 2008. But it turned into both a belief (neatly backed up by academia) that finding the companies with the best potential for growth is all that matters for long-term investing success, and an unnatural division of the market into growth stocks and value stocks.
Those investing in the latter have spent the past decade being derided as losers by the former. And those invested in the former have spent it being derided as optimistic fantasists by the latter. As I say: fun, but unfortunate because in the end the difference is less clear cut than it looks.
A recent note from Ben Inker at GMO looks at the traps you might find yourself in with both. One of the things growth investors most like to take value investors to task for is the risk that they will end up investing in value traps – that is, stocks that look cheap on a valuation basis but just keep getting cheaper because they have both “disappointed on revenues in the last 12 months and seen...future revenue forecast decline as well”.
The criticism is perfectly valid. Inker points out that every year “about 30 per cent of stocks in the MSCI US Value index turn out to be value traps, and they underperform that index by 9 per cent on average”. That said, there is something more common than a value trap: a growth trap.
Every year about 37 per cent of the stocks in the MSCI US Growth Index turn out to disappoint on current and forecast revenues. They underperform by an average of 13 per cent. This might not have mattered much in the go-go years when underperforming still meant making money. But when the base case is losing money (growth stocks have had a horrible year), and when stock markets hate uncertainty even more than usual, it does matter.
As Inker points out, value companies are already cheap by definition, so the pain of disappointment often doesn’t mean valuations falling much. But growth stocks are valued purely on the expectation of growth. Without that they are nothing, and so can be expected to fall very dramatically. Which they have. Over the past 10 months growth traps have underperformed the growth universe by 23 per cent. Not long now and they will be value stocks – or for that matter value traps.
There’s a lesson in here. Good stories make us forget the one enduring truth of markets: unless you are a very rare trading genius in the end your returns will not be a function of the stories you believe most but rather a function of the price you paid in the first place. It is pointless to say don’t hold value traps or, more importantly, growth traps – no one does it on purpose.
A better takeaway is to remember that when reality hits stories, reality wins. There was a rally under way in markets last week. A perfect moment to ditch the definitions (and the derision), rise above the stories and try to wriggle out of the traps. - Copyright The Financial Times Limited 2022
The writer is editor-in-chief of Money Week
