The last several months have been tough ones for growth stocks. MSCI U.S. Growth has underperformed its Value counterpart by 16% in the first 4 months of 2022 and had a tough end to 2021 as well. But while the median growth stock has indeed had a lousy time of it, the pain has been far from indiscriminate. The group that has been far and away the most painful for investors has been “growth traps” – growth stocks that disappoint relative to analysts’ forecasts. Even against the backdrop of lousy overall returns for growth since last summer, growth traps have managed to underperform the broad growth universe by their largest margin for any comparable period in history. Given the conditions that prevailed a year ago – some of the highest valuation premia for growth stocks ever and the highest median growth forecast for growth stocks on record – this shouldn’t have been a particular shock. As we look at current conditions in the growth universe, we expect growth traps to remain more painful than normal for some time to come.
What do Netflix (NFLX, Financial), Peloton Interactive (PTON, Financial), Coinbase (COIN, Financial), and Palantir Technologies (PLTR, Financial) 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.
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