3 Pitfalls Growth Investors Need to Avoid

risk tolerance - 3 Pitfalls Growth Investors Need to Avoid

Source: Shutterstock

Growth investing isn’t as easy as it has looked over the past decade. Not even a global pandemic and significant economic contraction — both of which generally lead to a focus on risk tolerance and thus a shift away from high-multiple growth stocks — has slowed the group. Growth has led the market for years now and is doing so again in 2020.

The trend will change at some point. By most measures, the market as a whole is at its most expensive in at least two decades. Simple math dictates that growth’s biggest winners will have to see their rallies at least slow down. The risks that spooked investors in March haven’t completely disappeared yet.

To be sure, that doesn’t mean growth investing is dead. It doesn’t mean that the long-awaited “rotation from growth to value” is at hand. With so many long-term trends boosting tech stocks, in particular, high valuations and a long-term focus make at least some sense.

But at this point, investors in growth stocks need to be careful. The margin for error is smaller, while the common mistakes remain. Here are three of those mistakes:

Misunderstanding Valuation

Growth stocks have higher multiples to earnings because those earnings are growing faster. Investors will pay more for a dollar of profit this year (or next) if those profits in turn will be far higher five or ten years down the line.

Those higher multiples offer two dangers. First, if growth slows, the multiple has to compress as well. That creates a “double whammy” effect. A lower multiple and lower profits combine to create a sharply reduced stock price. Second, it’s possible for a stock simply to get too expensive. Even the most bullish scenarios can be priced in, leaving a dangerous “heads I win a little, tails I lose a lot” situation.

But it’s worth noting, particularly in this market, that misunderstanding valuation in growth stocks can lead investors not just to buy losing stocks, but miss out on winners. After all, the market’s best stocks in recent years — names like Tesla (NASDAQ:TSLA), Shopify (NYSE:SHOP), and Amazon.com (NASDAQ:AMZN) — repeatedly have been called “too expensive.” (Sometimes by this very author.)

“Edge computing” play Fastly (NYSE:FSLY) is an instructive example of this potential pitfall. FSLY stock looks obscenely expensive. It trades at 2,944x Wall Street’s estimate of earnings for next year.

But that consensus estimate is for earnings of just four cents per share. Wall Street profits in the range of $4 million — roughly 1% of next year’s revenue.

Fastly’s margins are going to expand dramatically from that point. That alone will lead earnings to spike. Improving margins just five points — which is not that difficult at this point in Fastly’s growth cycle — alone improves profits by a factor of six. Add in revenue growth and that multiple starts coming down in a hurry.

This is not to say that FSLY stock necessarily is cheap or a buy. (At this point, I’m personally a bit skeptical.) Rather, it’s to say that using a single metric when understanding growth valuations is a good way to erroneously believe that a stock’s run is due for an end.

Anchoring

Another good way to miss out on upside is to fall prey to anchoring.

Anchoring is not purely an investing concept. Rather, it refers to the fact that we often overweight the first piece of information we receive.

The first piece of information investors often receive is the stock price. What often happens is that we then compare it to past prices to see if the stock is “cheap” or “expensive.” Often, a stock that has gained big seems more expensive; a stock that has fallen seems cheaper.

Neither is necessarily the case, however. The market is a dynamic environment, constantly updating its prices to account for new information. What most likely occurred is that the stock that has risen offers ownership in a company that has performed better than expected, or whose industry has newly higher growth prospects. Conversely, the stock that has declined often (though obviously not always) has declined for good reason.

Here, too, Fastly is instructive. The stock at one point gained a staggering 530% this year. Surely, an investor might think, the rally has to be at an end. In fact, combined with the nearly 3,000x price-to-earnings multiple, FSLY looks like an easy short. But an investor could have made a quite similar argument when FSLY was up 250% so far this year.

Of course, investors can get in trouble in the other direction. A stock that has plunged could look like a buying opportunity. But with growth names, a plunge often means the story has changed, and not for the better. (“Big data” darling Alteryx (NYSE:AYX) admittedly is a recent counter-example.) A “cheaper” growth stock is not necessarily a better one.

Particularly for growth stocks, past performance doesn’t suggest that the stock is “due” for a pullback, or that the rally has to end. These are stocks whose valuations generally rest on projected profits a decade or longer from now. It’s no surprise that the market’s expectations for those profits can change significantly in the present. As those expectations change, so does the stock price.

Going Beyond Risk Tolerance

That focus on the long-term gets to the third common pitfall: investing beyond risk tolerance.

Growth stocks are going to be risky. There’s no two ways about it. Investors in the group are making an enormous amount of assumptions based mostly on educated guesses. Will the company defeat its competition? How large is the market? How profitable is revenue at maturity? Will another technological change upend the market before maturity even arrives?

These questions of course are interconnected as well. Weak market share leads not only to lower-than-expected revenue growth, but disappointing profit margins as pricing power diminishes. The result is a vastly different valuation.

And so investors in the growth area need to understand their risk framework, because volatility will persist. In the February/March sell-off, FSLY, TSLA, and SHOP — again, three of the market’s best stocks — all lost at least 40% of their value.

Obviously, they’ve rebounded (and then some). But investors who went beyond their risk tolerance before the plunge may well have missed the rally from the lows. There’s no surer way to wind up panic-selling than to invest money you can’t afford to lose. Once again, FSLY proves an example, as it has plunged after-hours on Wednesday following soft guidance.

It bears repeating: growth investing is difficult. It entails trying to value not what a company is, but what it will be.

That’s hard enough. Investing beyond one’s risk tolerance makes it even more difficult — and in falling markets, sometimes impossible.

On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article. 


Article printed from InvestorPlace Media, https://investorplace.com/3-pitfalls-growth-investors-need-to-avoid-risk-tolerance/.

©2020 InvestorPlace Media, LLC