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The Growth Trap

A recent rereading of Jeremy Siegel’s The Future for Investors (a favorite of mine) reminded me of a lesson from the book that I found particularly valuable.

Siegel uses the term “The Growth Trap” to refer to the common investment mistake of assuming that a company (or an industry, or a country) is a good investment simply because there’s reason to believe that it will grow over the next several years.

For example, it would be easy for anybody to see that Google’s revenues and profits are likely to grow over the next decade. As such, many investors would be inclined to believe that this would make Google a great investment. The problem with this line of reasoning is that a certain level of growth is already built into the price. In other words, the current market price of Google stock (whatever it may be) is already based upon a certain level of assumed growth.

In order for an investment to earn above-average returns, the underlying company doesn’t just have to grow. It has to grow at a faster rate than everybody else has estimated. (Please note: “Everybody else” is–primarily–a group of full-time experts. So in order to be successful in such a wager, you need to have some information that they don’t have.)

If the company ends up growing at a rate that is equal to the projected rate of growth, its stock will earn a return that is roughly equal to the average return of the market. Similarly, if the company grows at a slower rate than has been projected, the company’s stock will actually underperform the market. (Yes, this means that a company can be growing–perhaps even very quickly–while its stock is earning below-average returns.)

The Shrinkage Trap?

Siegel never gives it a name, but the opposite mistake is just as easy to make: Many people assume that just because a company (or industry, or country) is declining, it must make a poor investment. That’s simply not true. If it’s obvious that a company is in decline, then–you guessed it–there’s a certain amount of decline in net income that has already been built into the share price.

How well the investment performs is entirely a function of how quickly the company declines in comparison to how quickly the market has projected it to decline. (And yes, this means that a company’s stock can be earning above-average returns even while the company’s net income is declining–just so long as the company’s rate of decline is less than the rate of decline that had been projected.) 🙂

In Summary

In short, what ends up being relevant isn’t whether a company is growing or shrinking. The only thing that matters is how quickly the company grows (or shinks) in comparison to how quickly the market (made up of countless experts) thought it would grow (or shrink).

My takeaway: In order to successfully beat the market by picking stocks, it’s not sufficient to know that a company’s profits will grow over [whatever time frame you’re considering]. You have to have reason to suspect that the company’s profits will grow at a rate faster than the rate that has been projected by all the analysts. It seems to me that that is a difficult prediction to make successfully.

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Comments

  1. This is a great article! I couldn’t agree with you more. Many times I hear people say that since “such and such a company” is so much lower in price now compared to 6 months ago, then it’s a great buying opportunity. WRONG. If it’s such a great buying opportunity then why has the stock been crushed?
    Granted there is a point at which a stock can be under valued, however you should never by a stock based on where it has been, you should buy it based on where it is likely to go in the future!

  2. Hi Justin. Happy to hear you liked the article. 🙂

    Yes, people’s misunderstandings of stock valuation lead to investment mistakes unfortunately often.

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