If there is something that Indians get more excited about than cricket and their morning cup of tea, it is getting a good deal. In the world of investing, sometimes that shiny, fast-growing company catches one’s eye and makes you sit up and take notice. As a prudent investor, it would be wise to be wary; just because something looks exciting doesn’t mean that it is always a good buy. Sometimes, it is difficult to discern a growth trap from an actual opportunity.
For the uninitiated, growth traps are situations where even some of the best investors invest in highly valued companies because of the expected growth and story that has been touted—good companies do not always equal good valuations. As the story falters, so may the valuation, and sometimes painfully.
A case in point is Tesla, once the poster child of the growth investor and a conversation starter around cocktail parties, which is down around 60% from its highs as its growth trajectory becomes more opaque.
The gravity of attraction: Growth trap number one
Have you ever noticed how the best and shiniest seem to grab the most eyeballs, even in the business world? EV, AI, and space-related industries are some recent examples. High-growth industries attract many aspiring entrepreneurs, investors, and established companies. However, over time, some of these industries stop generating higher returns due to the increased competition, which eventually leads to once-glittering companies getting derated in the future.
There seems to be some disparity here. We invest in stocks in the hopes that our chosen pick has embarked on a journey to potentially increase returns from present levels, but the gravity of attraction actually leads to de-ratings in the company because of the increased focus on the sector.
‘Buy at any “price”— Growth trap number two
Market information becomes more accessible every decade with advances in technology and data analytics. However, thanks to the improved ways of screening for stocks, some investors may crowd into companies that are benefiting from high growth rates but at the price of high multiples. This excitement may be further ‘endorsed’ by media outlets crowning their achievements.
Take the recent example of Zoom. During the pandemic, the company definitely experienced high growth rates as a result of the lockdown, and the term “Let’s Zoom” became part of everyday life and still is. However, while usage and the stock price soared based on the beliefs at the time, in recent times, both have since moderated.
This makes us realise that sometimes there are a lot of longer-term assumptions that need to play out in order to justify the price. From the ability to monetise to expected increases in returns on additional capital invested, wonderful stories do not always end in glory. Also, de-rated multiples will likely be the first thing that gets impacted if there is a downward change in projections because, ultimately, re-ratings and de-ratings are not in an investor’s hands.
Unexciting is not always unexciting
Value guys sadly can’t always spin tales of excitement and disruption, and we are definitely not the most popular people at cocktail parties if there happens to be a conversation on investing. But for us, finding a good deal is exciting enough.
An interesting example is that of Nick Sleep from Nomad Partnership, who is renowned for finding good companies with good values. He bought Costco in the early 2000s, despite the company having lower margins and ROCE compared to its competition. Nick believed that this was actually the MOAT. It was unlikely that anyone would dare disrupt the pricing offered by Costco because of low returns, but this allowed Costco to grow both its business and, in turn, its valuations. Imagine that.
Even in a market like today, it is possible to find good companies where the market value is below what it costs to build the business. At times, one wants to invest in a company’s stock when it is on sale, and why not. Even if there is a correction, then one can still sleep at night knowing that there is some downside protection in the form of the balance sheet, and I’ll take that any day.
Arun Chulani, Co-Founder, First Water Capital
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Published: 01 Jun 2024, 11:39 AM IST
