Has The Demise Of The Growthsters Been Greatly Exaggerated?
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I was shocked. A friend e-mailed me the news that a well-known growth manager had shut down. I didn’t believe him. Just last summer I heard that manager self-promoting on the podcast circuit, trying to impress the audience with how sophisticated of a business-picker he was.
My friend was adamant that the news was true – he sent me an excerpt from the manager’s letter to investors announcing the closure of the firm. I am, of course, not privy to any details other than what I read, and so it’s totally possible that some personal issue led to the decision. However, the letter didn’t refer to one. There is also a much simpler explanation: a quick look at the manager’s portfolio reveals steep declines in prices for many of the holdings.
Another well-respected growth manager felt the need to provide a public early-March update. In it, he explained why the 20%+ decline in his portfolio year-to-date is completely irrational. A panic. Could it be because the stocks were overvalued at the start of the year? Nope, of course not. At least not according to the manager.
Well, I am no expert on this manager’s portfolio and won’t opine on it. However, at the risk of over-simplifying and painting with very broad brush strokes, let’s take a look at the growthsters’ hunting ground: the all-capitalization U.S. growth index, Russell 3000 Growth. I am sure I am missing many nuances, but why don’t you be the judge of how likely it is that high growth stocks were overvalued at the start of 2022:
Source: Bloomberg
A third thoughtful growth investor complained about unfair happenings in China as the reason behind negative returns last year. I am no expert on China, which is why I don’t invest there. So forgive me for my ignorance, but isn’t unfair happenings one of the main risks of investing there?
All of this begs the question: why are some of these growth managers making a big deal out of a relatively small sell-off over the course of a few months? Isn’t the premise of being a long-term growth investor to focus on the businesses owned and not worry too much about the short-term stock price gyrations? Is it purely an attempt to calm the fraying nerves of clients, or is there also a component of trying to convince themselves that everything will be OK?
One possible explanation is that as a group, the growthsters had enjoyed a long and pleasant ride in the stock market. Along the way, they got to beat their chests publicly about the high quality and attractive growth prospects of the businesses that they owned. The sophistication of their research and analysis. Their ability to generate high returns despite the seemingly high valuation metrics of their stocks.
Consider that from 2010 through 2021, the Russell 3000 Growth, an all-cap U.S. growth index, has averaged almost 18% annual returns! This substantially outpaced the Russell 3000 Value index, an admittedly imperfect representation of the all-capitalization value universe. Over the 5 years ending in 2021, the annual returns for the Russell 3000 Growth were even higher: almost 25% vs. 11% for the Russell 3000 Value:
Source: Bloomberg
That’s a lot of positive reinforcement from the market. Enough to instill a good amount of hubris if one isn’t careful. After all, how can one resist believing that they are an amazing business analyst and investor if their companies report good news quarter after quarter, and the stocks keep going up higher and higher regardless of valuation?
The reality is that a monkey throwing darts at the high-growth stock universe would have generated amazing returns. Anyone who thinks that either 18% or 25% per year returns in a 2% inflation environment (ahhh, those were the days!) is normal or sustainable, simply hasn’t studied market history. If some of those monkeys could talk, a few might be crafty enough to come up with a sophisticated narrative for why they are amazing dart throwers. Perhaps some such primates would be able to raise large funds off of performance-chasing investors. Or even get invited to a few podcasts!
Let me be clear: I am not saying that all growth investors are lucky monkeys throwing darts. Far from it – I think there are a number of highly skilled growth investors (more on this later). What I am saying is that you didn’t need to be highly skilled during this period to post phenomenal results. Nor to convince yourself or others that you are an amazing investor.
Put yourself in the growthsters’ shoes. Faced with such monster returns, would you humbly announce to the world that you got lucky because of a massive liquidity and speculative fever-driven sentiment shift in the way the market prices your stocks? That in the absence of an enormous amount of government easy money and the gambling by many market participants that ensued that your returns would be considerably lower? That would be a rare person. Most would ascribe all or most of their results to skill and seek to benefit accordingly.
We have also heard a lot of condescending commentary in the last few years about more traditional value investors. They didn’t get it. The market has changed, and they failed to change with it. New business models are here, and they are so powerful that old-fashioned value investing just doesn’t work. Or so some of the growthsters and many others said.
Now that perhaps the shoe is starting to be on the other foot, it would be tempting to say that all growth investing does not work or that those who succeeded using that approach just got lucky. That’s not the case.
I know of a number of thoughtful, good growth investors. I am highly confident that they didn’t just get lucky. Yes, the bubble of the last few years flattered their returns and made them look even better than they are. However, when we come out on the other side I believe that their skill will result in good or in some cases great long-term track records.
The problem is that for every such investor, there are many, many people who did just get lucky. The worst part? To most people, they look and sound just like the skillful growth investors. They publicly pontificate about their clever mental models. Their special research skills. And so on. They are really just self-promoters riding the wave and taking advantage of a period of favorable sentiment for the kind stocks that they traffic in.
Investing in high growth companies with little attention paid to valuations is a very difficult style of investing. By doing so, you are betting against base rate probabilities. Why? Because sustainable high growth is both very rare and very difficult to identify in advance. Besides, when practicing such a style high growth is not enough. The growth needs to be higher than that discounted in the stock price. And remember, those stock prices are set by many other smart investors.
So almost by definition, only a small percentage of growth investors will beat the market. However, those who are uniquely skilled at this style are likely to have a much larger margin of victory than most other styles. In this lies the danger.
Newcomers to investing see the outcomes through the rose-colored glasses of selection bias. They see the few spectacular successes of the growth investing approach and assume that they can do it too. Especially since this style of investing leans heavily on qualitative analysis. Phew, think the newcomers. No need to learn accounting or read the footnotes to the annual reports. They think that they can sit back in their arm chairs and translate their very high-level superficial business insights into excess returns. Most are very wrong, but you can see why it seems so tempting to try.
All of this makes it hard to figure out who is who. If the impostor growthsters have high returns and say similar-sounding sophistry to the real deal, how do you tell them apart? I don’t have an easy answer. It’s hard.
You would have to judge the quality of their decisions over a period of time, with that period including times when their style is out of favor. You do realize that all investing styles have periods, sometimes long ones, when they are out of favor, right?
That’s asking way too much of most investors in funds, even those claiming to be sophisticated. Frequently their due diligence, if any, is just a fig leaf to mask jumping on some manager’s high recent returns band wagon. And those among the growthsters who are particularly good at self-promotion take advantage of that to enrich themselves, usually at the expense of their clients in the long-term.
So is the recent sell-off in high growth stocks a short-term panic that will soon reverse? Where do things go from here? I don’t know, and I suspect nobody really does either. I do believe it’s likely that some really high quality companies have gotten oversold, and are starting to look interesting to a boring old “value” guy like me. At least that’s where I am spending my time fishing for ideas, since my intrinsic value approach can be applied to high growth companies as well as more mature ones. But only at the right price.
However, on the whole the markets and growth stocks overall are far from cheap. If history is any guide, there is a decent chance that the next few years will hold some more market pain for the growthsters. That’s a good thing – it will help sort out the truly skilled ones from the pretenders. Once a bubble bursts, it’s rare for the same one to get re-inflated for a while.
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