Growth stocks. High beta. Sickening volatility in scary times. Yikes.
Many growth investors lately have felt a lot like Slim Pickens at the end of Dr. Strangelove, riding that nuclear bomb down into oblivion (screams of "YEEEEEEHAWWW!!!!" optional). The Panic of 2008 has been painful for everyone on the long side of the market, but while the S&P 500 is down about 40% off its 52-week high, many once-hot growth names have been hammered even harder. Apparel maker lululemon athletica
We have a lot of sayings to describe the stumbles of leaders. One goes, "The bigger they are, the harder they fall." Or, if you prefer, "The brightest candle burns fastest." But the inverse can also be true. The stocks that have taken the worst abuse can rise the furthest as the market recovers and give investors outperformance to match or beat their previous underperformance.
One way investors try to quantify this effect -- and identify opportunities -- is by chasing beta, the measure of an asset's volatility against a broader index. The basic idea is to buy high-beta stocks when you expect the market to start rising.
But I wouldn't recommend it.
Betting on beta
A stock with a beta of 1.0 is exactly as volatile as its benchmark, typically the S&P 500. So if the S&P 500 rises by 20%, a stock with a beta of 2.0 should rise 40% ... and vice versa. That would seem to make high-beta stocks a bad thing to hold when the market is declining, but a great thing to load up on as the market turns. And indeed, some investors pursue exactly this strategy as a way to juice their portfolio in anticipation of an upturn.
Proceed with caution. While high-beta stocks should theoretically rise further in an upswing, there are a few caveats to consider.
One, of course, is that beta is a measure of what the stock has done in the past, and we know that's an imperfect gauge of the future. But the second reason for caution is somewhat more complicated. Because a stock's beta actually describes a combination of its volatility and correlation to the market, the figure may give misleading information.
For instance, just because a stock has a beta of 0, that doesn't mean its price never moves -- it just means its movements have no correlation to the market. It could be very tame or incredibly volatile, but whether its gyrations were wild or docile, they would bear no relationship to the movement of the index it's compared with.
Not what you think
In fact, lack of correlation is the reason stocks that have massively outperformed the market often have lower betas than you'd expect. Take Intuitive Surgical
True, when the market went up, Intuitive Surgical generally went up more (high beta). But when the market went down, it still went up (that's inverse correlation, or negative beta). Intuitive Surgical has the kind of volatility you want: It's heavily skewed to the upside. That doesn't get reflected in beta.
That doesn't mean fast-growing companies won't outperform the market in an upswing. It's just that easy shortcuts, like beta or index funds, tend not to work all that well for growth stocks. Yet there have been some incredible growth investments over the past several years, some of which we spotted early in our Rule Breakers service -- not just Intuitive Surgical, but companies such as Myriad Genetics
Of course, even though we're slightly better off than the S&P 500 since inception, we're still seeing a lot of red on our scorecard. But we're in a great place to see outsized returns as the market eventually turns around. Not because of beta. Not because we've cast a wide net. Rather, because we've selected specific companies with sustainable competitive advantages. And because the current pessimism, while it is depressing most stocks, depresses growth companies the most.
Some former growth darlings may never recover -- if their advantages were illusory, their businesses have changed, or they are simply too small and undercapitalized to execute their business plans in a hostile environment. But some will come roaring back in the inevitable upswing. The bad news is that the best way to find them is one at a time.
With that in mind, we recently took a team of Rule Breakers analysts on an "Innovation Tour" of Silicon Valley. We went looking for the best the tech sector has to offer, and after meeting with company management teams and venture capitalists, we have a few ideas.
Want full access -- for free -- to our trip dispatches? Just click here, enter your email address, and tell us where to send the first dispatch.
Karl Thiel owns shares of Apple but of no other companies mentioned. Baidu.com and Intuitive Surgical are Rule Breakers recommendations. Apple is a Stock Advisor selection. The Fool is investors writing for investors.