Growth stocks, fear, and maintaining the right mindset.
The market has been tough for growth investors over the last few weeks.
Two factors have contributed to the increased volatility, particularly for growth stocks. Firstly, rising inflation has increased the likelihood of higher interest rates. When interest rates rise, future profits are worth less, and this affects growth stocks more than other types of investments.
In addition, some companies have lowered their guidance for the current quarter. The market is now concerned about the sustainability of growth rates we have seen over the last
There have also been some irrational price movements, Adobe being a good example. Adobe is a very profitable company now generating $5 billion a year in free cash flow. Yet, the stock was punished like a highly speculative stock when Adobe lowered guidance last week.
The growth investor mindset
Irrational, kneejerk reactions occur when markets are driven by either euphoria or fear. Currently, it’s fear that is causing investors to panic and overreact.
During periods like this, it’s important to take a step back and revisit your objectives as an investor. Every approach to investing has a unique set of pros and cons, and requires its own mindset.
Growth investors have the opportunity to own companies that can appreciate five, or even ten-fold in price. But to own companies like that you will need to tolerate drawdowns and volatility. A few months ago I covered the drawdowns that have occurred in the prices of some of the best growth shares over the last few decades. If you missed it have a look here. The bottom line is that the stock prices of companies like Amazon, Netflix and Apple have all fallen 50 to 80% from their highs on multiple occasions.
Value investors experience less volatility (though they can still face a fair amount), but their investments don’t appreciate nearly as much.
Momentum investors and traders can, in theory, ride the big trends, while avoiding the drawdowns. In reality, getting the timing right is more difficult than it seems. Typically, market timers sell too soon, and then end up buying in again at higher prices.
Risk and volatility
The words risk and volatility are used interchangeably, and volatility is often used as a way to quantify risk. But volatility is actually just one type of risk. And growth investors probably focus too much on volatility risk, and not enough on the other risks.
If you are investing in growth companies, volatility should be expected and shouldn’t be a cause for concern – as hard as that seems.
The real risk is the likelihood of a company being able to grow enough in a five-to-ten-year period to generate a return relative to the price you pay. To manage this risk you need to consider the following questions:
How big is the company’s total addressable market?
Does the company have a proven business model?
Who are the competitors, and can this business defend its business and margins?
How much growth is already in the share price?
If you are going to worry about anything, it should be these questions rather than volatility and drawdowns. Ultimately, what counts over the long term is owning companies with a proven track record and a long growth runway ahead of them.
The current fear and volatility are the result of inflation concerns and lower guidance heading in to 2022. These may affect valuations right now, but mean very little when we look at the big picture. There will always be a reason to sell a stock if that’s what you want to do. But successful investors don’t make money by selling their stocks every time volatility increases – if anything this is the time to add to positions.