Are Growth Stocks Bad Investment Vehicles?

Earlier today, I tweeted a joke about the performance of $COH

If u had invested $1000 in Coach in 2006, today u have … $1000. Sometimes, it’s better to buy a bag. $COH

— Ivaylo Ivanov (@ivanhoff) Jun. 4 at 06:50 AM

And yes, I didn’t account for the dividend that Coach paid, but you get my point.

What is more interesting is some of the reactions I received on social media:

First of all, let me tell you that I love the fact that people have  a disdain towards growth stocks. The recent declines in many cloud, Internet and social media stocks have scared people out of story/momentum stocks. This sentiment is usually a good foundation for future outperformance of this asset class.

For a market approach to work in the long-term, it has to go through periods of underperformance, when most people lose faith in it. It is the law of the market and it applies to both value and momentum.

If your strategy is to buy and hold forever, growth stocks are not for you.  Go buy a few boring, dividend-paying consumer staples at a fair price and you will do well over time. It is not an accident that Buffett likes to buy only businesses, which circumstances are not going to change substantially in the next decade. Guess what – if a business doesn’t change too much in 10 years, it is very likely that it won’t do much better than the market itself.

If your goal is to trump the market averages, growth stocks are the place to be.

It is true that many growth names will go up 300-400% in a couple years, only to give back 50% to 90% of their appreciation afterwards. Does that mean that you have to ride those stocks all the way down? Does that mean that you have to look at the glass as half empty? No. If you have a proper exit strategy, you will protect the majority of your profits and then re-invest the proceeds in other emerging growth names.

Some trends last 3 months, some trends last 2 years; others last 10. Eventually, every price trend and every growth story comes to an end. This end could be very different, depending on your exit rules.

When to Buy and When to Sell – How Size Changes Everything

In capital markets, size matters a lot, even more than you probably think. It could define not only the assets you could trade, but also your buying and selling strategy.

If you manage 200 million and your average allocation is 5%, you are very limited to the type of stocks you could engage with. With an average allocation of 10 million dollars, you cannot afford to by a ten-dollar stock that trades 200k shares a day. Even if this $10 stock trades 1 million shares a day, you would have hard time buying 100% of its daily dollar volume without getting substantial slippage. This is why we say that when elephants dance, they leave traces. When big funds buy, they show their hands, they reveal their intentions. It is almost impossible for a big fund to buy its entire position in a mid-cap in one day.

Because of liquidity constraints, large funds:

1) cannot swing-trade. It takes several days/weeks to establish a new position and just as many to sell one.

2) cannot own individual small cap names, because they cannot establish position that is big enough to make a difference; guess where the best performing stocks come from, every single year.

3) sell on strength when there is enough demand to absorb their supply. If they wait to exit their entire position on a trend break (weakness), they will get a lot lower price as liquidity tends to magically disappear just when they need it the most.

4) buy established trends on weakness (pullbacks) or accumulate in anticipation of a a new trend – they realize that they won’t be able to build a big enough position when the stock of interest breaks out.

5) love market corrections. The two most favorite words of many value investors are forced liquidation. They live for that once a 2-3 years deep market pullback that allows them to accumulate positions of interest on the cheap. Momentum investors also embrace deep market corrections as they reset many bases and facilitate the discovery of big future winners.

Smaller market participants have an incredible advantage.

We could chose to wait and buy a breakout, because we don’t have the liquidity constraints to build our positions. By waiting for a breakout, we optimize our capital allocation – we are making sure that we are invested only in names that are already moving in our direction. We could be in and out of a name inside a day.

Or we could buy a trending stock in anticipation of a breakout, knowing that institutions are likely to support it. Bull flags are typical trend continuation patterns. Do you know how they are formed? Basically the process is the following:

1) there is a catalyst (earnings or price related) that causes a stock to break out;

2) let’s say that in our example, our stock of interest runs from 30 to 40 in a week;

3) it is normal to expect some form of mean-reversion after such an explosive move – either through time or through price

4) Institutions that are not willing to chase, could just put a big bid at 38, so every time this particular stock drops to 38, supply will be absorbed.

5) The stock will remain in this 38 to 40 range until the entire supply is absorbed and there is enough demand to push the stock higher.

We don’t need that much liquidity to exit. We could sell on strength or we we could sell on weakness, when there is a clear technical indication that the trend is over.

When people judge the performance of billion-dollar hedge funds, they need to realize how constraint those funds are in terms of opportunities. Which brings the question – why would you even consider allocating money to what is essentially a big huge asset gatherer? You are buying a ticket for almost guaranteed under-performance.

Know Your Process

It is said that the definition of insanity is doing the same thing over and over again and expecting different results. The thing is that if you do the same thing over and over again in the market, you will get very different results, because the market environment constantly changes. The same type of swing setups that have 80% success rate and average 20% returns in a healthy bull market, could have 15% success rate and 10% returns in a choppy market. The same market approach (process) could have extremely positive or extremely negative expectancy, depending on the market environment.

Expectancy is the average gain per every taken signal. Highly positive expectancy means that you have an edge.

Expectancy = %of winners * Avrg. return of winners – % of losers * Average return of losers

Let’s assume that no matter what the market environment is, we keep our losses to 6% on average. What are the results in a healthy and in a choppy market?

Healthy market

Expectancy = 0.8*0.2 – 0.2*0.06 = 14.8%, which means that if your average capital allocation per signal is 10%, the average profit per every taken trade will be 1.48% of your capital. If you take 100 trades in this environment, your return will be 148%. (not taking into account that the absolute capital allocation will change as your capital grow).

Choppy Market

Expectancy = 0.15*0.10 – 0.85*0.06 = -0.036 or -3.6%. If your average capital allocation is 10%, then your average return per every single taken trade will be -0.36% of your capital. The more active you are in this environment, the more money you are likely to lose. In this case, we basically have 4 options to help us mitigate the damage:

1) trade less

2) use smaller position size (1/3 to 1/2 of your usual)

3) sit on the sidelines

4) use another approach that has a positive expectancy in this market environment (also known as an edge)

We don’t know in advance what trade is going to work, but we could have a very good idea when we have an edge and when we don’t.

I like to repeat that sometimes being wrong in the market is not a choice, but staying wrong always is. The truth is that more often than not being wrong in the market is a choice, kind of. If you know when your bread & butter process does not deliver in certain market environment and that you are very likely to encounter a loss, don’t push it, don’t be more active.

Many people know when their market approach is not likely to deliver good results, but most don’t have the discipline to step away and watch mostly from the sidelines. I have to admit that I have been one of those people. I am very good at knowing when to trade less and cut my position size, but at the end of the day when I draw the line, it turns out that in this specific environment I would have been better off doing nothing and sitting on the sidelines.