COMMENT: There’s real pain for investors in highly-rated companies that don’t deliver.
‘We’re still growing, right? So, it’s not that we’re shrinking there, but it’s growing at a lower pace than anticipated.’
So said Pieter van der Does, CEO of leading fintech payments company Adyen talking about its US operations on an earnings call last month.
Three trading days later the Adyen share price was down 47%, a €21bn hit to funds that hold shares in the company.
So what happened? Why did a €37m shortfall on sales – less than 5% – create value destruction on a massive scale?
The trouble is that when you’re trading on a price-earnings (PE) ratio of 60 times forecast profits, there’s no margin of safety; meeting or exceeding forecasts is everything.
Bringing the best to everyone – or not
Tech or beauty, it’s the same story if you trade on a high multiple.
Back in February 2022, Estée Lauder’s CFO proclaimed that ‘we delivered an exceptional first half characterised by strong and diversified double-digit organic sales growth and disciplined cost management.
‘Looking ahead, we are raising guidance to reflect our expectation for a strong year.’
The shares were then priced at 38 times forecast earnings and the company ticked the ‘quality growth’ box.
Three months later the company lowered expectations caused by the ‘impact of the temporary Covid-driven restrictions in China’.
A string of earnings disappointments since then suggests China’s challenges had not been temporary.
Fast forward to last week, and more heartache for funds that still hold the shares, as the company said: ‘For our first quarter, we currently expect organic net sales to fall 12% to 10%.
‘At this time, we expect first quarter diluted EPS of negative $0.31 to negative $0.21 before restructuring and other charges.’
Declining sales and losses are not what shareholders want when they pay high prices based on forecast earnings. No surprise then that the share price has fallen 40% this year. The problem is that fiscal 2024 earnings forecasts have fallen just as much, so the company is still priced at more than 34 times forward earnings.
Traps of many kinds
Investors are often warned that they should be careful of the value strategy because of ‘value traps’, but what if ‘growth traps’ and ‘quality traps’ are far more hazardous to your wealth?
Ben Inker and the team at GMO did some empirical analysis on this topic in their excellent piece, Growth traps snap shut in May 2022.
They defined a ‘trap’ (value or growth) as ‘a company that both disappointed on revenues in the last 12 months and saw its future revenue forecast decline as well’.
Their analysis also showed that growth traps are more dangerous than their value counterparts because they are:
- More common – 37% of growth companies underperform the MSCI US Growth index.
- More painful – with an underperformance of 13% on average.
So the question is: why?
Multiple metrics…
This may be the answer. Value stocks often have more than one metric supporting the valuation
One of our fund’s largest holdings, Dutch bank ABN Amro, trades at 5.5 times earnings estimates for 2024, has a 10% dividend yield and is priced at just 0.55 times tangible book value.
If ABN Amro’s earnings were to disappoint, even unexpectedly halve, the PE ratio would rise to just 11 and still trade at a substantial discount to the 17 times earnings for the MSCI World index.
It would still be on 0.55 times tangible book value and have a dividend yield of 10%. Even if the dividend was halved, it would still yield 5% – nine times more than that offered to Apple’s shareholders.
In other words, even if value stocks disappoint, they’re often still cheap.
…are better than one
But you are in trouble if you only have earnings growth to rely on. When that falters like at Adyen or Estée Lauder (or indeed Zoom or Peloton or every company at some point), there is nothing else to fall back on.
Lower earnings growth demands a lower PE multiple, but then pair lower earnings and a lower PE and you have a double negative whammy, leading to a much lower price.
Contrast this with ABN Amro where the starting PE is already low, and it’s easy to see why this de-rating is far more painful for growth stocks.
When growth goes wrong
In my experience, the worst investments are expensive companies that have gone ex-growth because they no longer meet the mandate for growth investors and are too expensive for value investors – meaning there are few marginal buyers. That’s why you get the calamitous fall for Adyen we saw last week.
In contrast, the best investments are often cheap companies that start growing unexpectedly because now you have higher earnings growth deserving a higher PE – a positive double whammy. Now their trend attracts an additional source of demand in growth investors.
What next?
We live in very uncertain times. Take interest rates, central bank actions, China, the war in Ukraine, commercial real estate, consumer debt and future unemployment levels. No one knows where they are heading.
Yet most of the world’s investments remain very concentrated in large-cap US growth companies priced for perfection in an imperfect world.
Somewhat concerning for many portfolios today, Inker’s team also found that ‘when growth stocks trade at a higher-than-normal premium to value stocks, the underperformance of growth traps is more extreme’.
With the pervasive uncertainty that exists today, there may be merit in having more exposure in value-oriented funds to reduce reliance on the uncertainly of earnings growth forecasts.
The recent sharp falls in the share prices of Adyen and Estée Lauder serve as useful reminders of what can happen when that earnings growth is at a ‘lower pace than anticipated’.