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OPINION

Overpriced growth

Overpriced growth
March 16, 2017
Overpriced growth

Why do growth stocks do badly? There are several possibilities: investors are overconfident about their ability to predict future growth; they pay too much for the small chance of big pay-offs; and they are seduced by glamorous growth stories to the neglect of more solid defensives.

However, Charlie Cai at Liverpool University has come up with another explanation. He and his colleagues say it's because investors have limited attention. They focus too much upon a stock's recent growth - often because this has propelled it from obscurity into the public eye - and neglect the fact that rapid growth can often reduce profits.

There are several ways this can happen; managers focusing upon expansion can forget to control costs; companies can over-estimate demand and so expand too much; it can take longer than expected to get new equipment working well; or rapid growth can attract competitors into the market.

Mr Cai shows that there's a negative correlation between the growth in a company's assets and the two drivers of returns on capital: asset turnover (the ratio of sales to assets); and net profit margins. And, he shows, in industries where asset turnover and profit margins are most negatively sensitive to growth, investors are most likely to pay too much for growth stocks. This is consistent with them focussing too much upon what's obvious (growth) and too little upon what's not so obvious: the tendency for growth to depress returns on capital.

In this sense, investors make the same sort of mistake the French economist Frederic Bastiat warned of back in 1850; they pay too much attention to what's obvious and neglect important forces. The bad economist, he said, "pursues a small present good, which will be followed by a great evil to come". The bad investor does the same thing.

Why don't cleverer investors realise this and bid down the prices of growth stocks? It's because it's risky and sometimes impossible. Growth stocks are often volatile and (if they're on Aim) sometimes illiquid too. This makes them difficult to short-sell. And even if you can short them, there's a risk that over-priced shares will become even more over-priced before reality hits them. It's not enough to be right: you have to be right at the right time.

All this suggests that buyers of growth stocks must ask tough questions. Is the business scalable? Can it expand efficiently without losing control of costs? Will demand really keep pace with management's expansion plans? Can it fend off competition and so achieve decent margins? These questions are hard to answer. But history warns us that the answers are often: no, no, no and no.

Investors too easily forget that the purpose of companies is to make profits - and that it is difficult to do so.