Mind the GAAP: Beware squeezing growth stocks for all their worth
Growth stocks have significantly outperformed value counterparts and could climb further from here, but astronomical price to earnings ratios should be a cause for alarm for investors, RWC Partners’ Graham Clapp has said.
Growth investing has been in the ascendency for a large part of the last decade. Many growth companies – particularly those considered to be GARP (Growth At a Reasonable Price) stocks – have soared as a result.
A well-established investment strategy, GARP looks to combine both Growth and Value to provide investors with attractive opportunities where prices have not run ahead of fundamentals.
However, after such a long spell of gains, Clapp says investors need to be vigilant that GARP stocks haven’t become GAAP stocks – known as Growth At Any Price.
Clapp, manager of RWC’s European equity team, believes these stocks are unlikely to produce strong returns going forward, especially if the tentative signs of the rotation away from Growth and Momentum into Value continues.
“It’s hard to call exactly how far the elastic band can stretch on value vs growth, but we are seeing a complete bifurcation of the market now. Dependable earnings have re-rated significantly and volatile earnings have de-rated. But it’s not necessarily over yet,” Clapp says.
“Some stocks which used to trade on 20-25 times earnings are now more like 30-35 times, but they could go to 40 times.
“Nonetheless, you are seeing cracks emerging and the market being less forgiving. We are not saying don’t own any of these stocks if they hit these levels, but you have to be far more selective, as elevated prices mean there is no margin for error.”
The valuation expansion has manifested itself most visibly in sectors where there is strong, predictable, above-GDP organic growth that investors do not expect to fade, with Healthcare or Technology particularly in favour.
However, analysts often overestimate growth potential to justify their recommendations, according to Clapp. This can lead to the risk of a painful combination whereby companies miss expectations whilst sitting at an elevated valuation.
The higher the growth and multiple, the more painful the multiple contraction is if growth begins to slow. Therefore, he says the ability to identify the key drivers of earnings is extremely important in this market environment.
“The impact of low interest rates and crowded positioning on growth companies deemed to have a defensive moat has resulted in these companies becoming highly rated relative to history,” he said.
“Whilst valuation is never the starting point for an investment thesis, we have to be prepared to Mind the GAAP in these cases.”
Nonetheless, he says there are still opportunities in areas which have been popular in recent years.
“The trends from 2019 are not over. Areas such as technology, and within that payments and software, are our main plays. Software in particular has de-rated somewhat, so there are opportunities there,” he says.
In terms of what he is avoiding, he warns it is easy to buy companies where valuations are depressed in the expectation they will snap back, only to find the environment they operate in has changed more than expected.
“A key part of our research process looks to identify those companies whose earnings are at risk of deteriorating significantly. When looking at the cheapest stocks in the market, disruption is likely to impact earnings more than expected, and so the business may still be expensive on a longer-term view,” he says.