Chasing growth can be dangerous??

Chasing growth can be dangerous

To illustrate this point, let's delve into some data by taking a journey back to June 2019, a time by which all companies would have disclosed their financial results for the FY19.

We'll begin by categorizing all stocks based on their valuation, specifically using the Price to Book (P/B) ratio, and then distribute them into 10 distinct groups.

We define the 'Growth' group as those stocks characterized by a high Price to Book ratio, whereas the 'Value' group consists of stocks with a low Price to Book ratio.

Upon analyzing the data, we observe a significant trend: stocks that had the highest P/B ratios in June 2019 have demonstrated a higher earnings CAGR over the past five years from FY14-19.

Conversely, companies that recorded the lowest earnings CAGR were found to be trading at the lower end of the valuation spectrum.

Commonly, investors are influenced by historical performance when making investment decisions. They often choose to invest in companies that have demonstrated strong earnings growth in the past, and are willing to pay a premium for these investments.

Similarly, the analyst community frequently projects recent earnings trends into the future, operating under the assumption that these trends will continue. (Representative Bias)

However, the principle of mean reversion is a critical concept frequently overlooked by investors. This principle suggests that over time, earnings and stock performance tend to return to their long-term averages, defying the expectations set by recent performance. Obviously, there will be a few exceptions to the norm, but this holds true in most cases.

The chart below illustrates the growth trajectory of the same group of companies from FY19 to FY23.

Take a moment to comprehend this data!

It is evident from the data that companies which exhibited high earnings growth from FY14 to FY19 have not maintained this performance in the subsequent years.

Investors who paid a premium for these stocks, expecting continued growth, have unfortunately experienced a decline in earnings growth. This has led to a significant erosion of wealth for those investors.

Let's look at a personal example, which has happened with us.

To be honest, we were young in the market and bought this stock on borrowed conviction of Rohit Chauhan and we continue to hold this stock till date.

This company was growing at upwards of 20-30%, but suddenly, its growth hit a speed bump.

How did market react to this?

Stock took a dive.

Market de-rated its valuation multiples from ~40x to ~20-25x on the expectation that recent low growth is likely continue into the future. That's what we analyst do? Don’t we?

But it was a temporary hiccup in a long journey. Eventually, the company reverted to its 20%+ growth.

Again, How did market react?

Stock got re-rated from low of 20x to hit a high of 65x in next few years.

Keeping in mind a simple mental model of “Mean Reversion” can be immensely helpful to find mispriced opportunities in the market. On this note, let’s conclude with a famous quote by late Mr. John C Bogle, the father of index investing and founder of Vanguard.

Fun exercise – Comment below If you can recognize the name of the company that we are talking about.