The problem with glamor stocks, as I see it, is that there is a huge disconnect between what analysts expect/model and what actually happens. A study by SG Global Strategy research (as discussed by James Montier in “Value Investing: Tools and Techniques for Intelligent Investment”) shows that from 1985-2007, analysts were relatively good at predicting growth in value stocks (predicted 10% per annum vs. 9% actual).
However, when it came to growth stocks, they couldn’t hit the broad side of a barn: Stocks expected to generate growth of 17% per annum delivered only 7% per annum on average over the next five years. In aggregate, analysts tend to be overly optimistic with their assumptions on companies that promise to be the next Microsoft (MSFT) or Apple (AAPL).
There are two relatively simple ways to avoid this error, this first of which is to stop forecasting. The futility of DCF models is widely known (see here), even without the added uncertainty that is inherently present in most growth stocks. However, without the story, there isn’t much left in a lot of cases (look at Internet companies at the turn of the century); for most glamour stocks, most of the implied market value is pent up in assumptions about the future. The simple solution for the intelligent investor: Don’t buy hype; buy companies with real assets and sustainable earnings power.
Another way to avoid this error (but not quite as simple) is to shed your behavioral biases (like over-confidence and over-optimism) and simply admit that you don’t know. Looking back ten years might be a sobering exercise if you think you know where Netflix will be in 2021. This strategy means being patient, but being ready to load up in a big way on value when it presents itself.
One of the most fascinating things I have ever read about Warren Buffett is that he waited three years (from 1985-1988) without purchasing a single stock after Berkshire’s Cap Cities investment. If the opportunities aren’t there at the right price, he would simply sit there with the bat on his shoulder and wait for the right pitch. As Warren has said before, “I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.” A look at his investment records suggests that 1-foot bars are more than adequate.
Regardless of the facts, many investors continue to hinder their performance by flocking to glamor. Additional data from SG Global Strategy research shows that from 1985-2007 (U.S. data here, but same relative result in Europe), investors were rewarded for sticking with the slow, boring, and unglamorous (a strategy that has been continually advocated by successful investors and ignored by many others).
Stocks with low historic growth and low expectations for the future returned 14.9% per annum during the period, compared to 9.9% for stocks with high historic growth and high forecast growth. The value portfolio outperformed by 5% a year over the 22-year period, suggesting that an initial $10,000 investment in value versus growth would have generated more than $130,000 in additional gains ($212,344 vs. $79,790).
The disconnect between price and value in most growth stocks is staggering. By looking at Under Armour (even after the 11% decline), we can see the optimistic expectations that are currently cooked into the price. When I run a reverse DCF at today’s price (assuming a 12% discount rate and long term growth rate of 6%), the $70 per share valuation assumes more than 20% growth per annum in net income over the coming 10 years. For the sake of comparison, the company has achieved 16.29% EPS growth over the last five years. The question is whether or not they can improve their historical EPS growth per annum; my answer is I don’t know. The beauty of my investment strategy (and that of value investors everywhere) is that I don’t need to forecast the future (thankfully, because I can’t). We are buying assets that are cheap based on today’s business, rather than on future events that may or may not occur. Certainly, besides in the case of cigar butt style investments, growth is a factor that cannot be simply overlooked. But there is a difference between buying Under Armour with the hope that earnings growth hits 20% a year for the next decade and buying Johnson & Johnson (JNJ) with the expectation that growth will not come to an absolute halt (which is what the price implies in the high 50s).
In the case of investment versus speculation, intelligent investors would be wise to avoid glamor and growth, and stick to boring value stocks.