Growing companies are the bikini-clad swimsuit models of the stock market: Beautiful, provocative ... and most of the time out of reach.
Their stories tempt us with the promise of bright futures. News of growth fills the headlines and sells newspapers and magazines. And their rising stock prices draw our eyes to the stock charts like ... you get the idea.
Unfortunately, growth companies create a problem.
Caution: Growth trap ahead
In The Future for Investors, Jeremy Siegel gives a very poignant warning:
The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth -- through buying hot stocks, seeking exciting new technologies, or investing in fast-growing countries -- dooms investors to poor returns.
Overpaying is the main problem, but how can we avoid paying too much for a growth stock?
Recognize feedback
There's an easy answer to this question -- and it's coming -- but first, we have to understand why the growth trap exists. It's feedback.
The stories of new, innovative companies attract early investors. Rising prices and more headlines draw in new investors willing to pay higher prices. Growing sales and profits and even more financial press bring more new investors who extrapolate high growth too far into the future and pay higher prices yet. It's the market's feedback mechanisms that suck later investors into the growth trap.
During the telecom investment bubble, Cisco Systems (NASDAQ:CSCO) and Level 3 Communications (NASDAQ:LVLT) were spearheading the tech revolution. Cisco was supplying the hardware to power the Internet, and Level 3 was building a new network full of bandwidth to carry the traffic around the world. Stories of their amazing futures plastered the headlines. Growth, growth, growth was all we read. Investors flocked to these companies in droves to be a part of the action.
If you weren't in Cisco or Level 3, your portfolio was falling behind. That's because expectations were so high that their stock prices kept going up, up, up. And then expectations changed. If you bought at the top, you could have lost more than 85% on each if you sold at the bottom.
Work backward
Once we recognize that feedback mechanisms may be driving prices up too high, we have to be able to work backward to find the expectations built into the price.
Expectations were enormous for Cisco and Level 3. At their peaks, the market expected them to grow fast for decades -- and, unfortunately, that just doesn't happen. Working backward, investors can resist paying too much by thinking critically about the growth requirements implied to justify their valuations. It's not easy, particularly when prices are rising, but it's what value investors have to do.
Develop your value radar
Finally, as value investors, we need to keep our value radar sharp. We have to be able to recognize and acknowledge growth traps when we see them. While allowing great stories to pass you by can be difficult, it's great stories at great prices that will make your portfolio.
But the best benefit of having a good value radar is that the feedback process also works in reverse -- and we can use it to spot bargains.
Today, Cisco and Level 3 are owned by some renowned value investors (Bill Miller of Legg Mason and Mason Hawkins of Southeastern Asset Management, respectively; Miller owns some Level 3 as well) who own shares at prices significantly below their all-time highs.
Other growth companies whose expectations, and prices, got ridiculously low are wireless provider Nextel -- before the Sprint (NYSE:S) merger -- and energy companies Williams Companies (NYSE:WMB) and AES (NYSE:AES).
In June 2002, slowing subscriber growth, heavy capital expenditures on upgrades, and fears its network would run out of capacity caused investors to push the panic button on Nextel and head for the exits. Hindsight is 20/20, but at its low, investors could have picked up shares for just more than one times forward earnings. That's an insane bargain!
Also in 2002, Williams and AES had a bunch of problems in the post-Enron meltdown: price fixing allegations, slowing growth, declining credit ratings, class action lawsuits. Both saw their share prices drop like stones. At their lows, both companies, by my analyses at the time, sold for less than their liquidation values. Sure, the threat of bankruptcy was real. But it wasn't likely, especially since their assets were generating cash. Why the market thought the companies should trade at less than liquidation value was beyond me. I'm just glad the market's feedback mechanism drove the price down to fire-sale levels.
From their lows, all three of these companies are multibaggers, with Williams up more than 1,500% and AES up nearly 1,800%.
The value advantage
Value investing has an inherent advantage over growth investing because while both strategies seek great stories, only value will keep your from overpaying for them.
If you'd like to learn more about the strategy, consider picking the brain of Motley Fool value guru Philip Durell. His Inside Value service is beating the market by nearly four percentage points, and he believes his picks are poised to keep beating the market three to five years down the road. All his ideas are yours free for 30 days.
Fool David Meier owns shares of AES but does not own shares in any of the other companies mentioned. The Motley Fool has a disclosure policy .
