Growth Trap

Growth Trap is discussed in Chapter 5. When an investor pays a high price for growth, this happens. Even though the stock is a growth stock, the investor receives no return because he paid a high price. 

Investors chasing growth stocks use heuristics to guide their behaviour. Heuristics for Availability: Everyone is talking about this stock, and investors make decisions based on readily available information. Sheepherding, Overconfidence bias: Because one is confident in their assessment, they underreact to negative information about the stock. Bystander effect: Even when one believes contrary to market expectations, one is hesitant to act on that belief. Information Cascade: imitating the actions of experts without conducting the necessary analysis and research The Halo Effect refers to making decisions based on only one prominent piece of information. The author uses multiple examples from Indian markets to demonstrate the growth trap. 

For instance, Century Textiles was a growing company in 1979, while ACC was a neglected stock. If you had invested ₹100,000 in each of these stocks in 1979, ACC would have provided a 6% higher return (equivalent to approximately ₹4,000,000 over 25 years) than Century Textiles. This is due to the investor overpaying for Century Textiles, a growth stock.

Lessons:

The key takeaway from the preceding examples is to look for businesses that have the fundamentals to outperform the expectations built into the prices. The more significant the difference between the intrinsic value based on quantitative analysis and the expected value built into the price, the better the results for an investor.
At any given time, very few of the companies traded on the stock exchange would pass the above expectations game test. However, if one can train oneself to recognise the behavioural anomalies that result in mispricing, one can expect to find some bargains. Some of the common behavioural anomalies among all fads and fancies that lead investors into the "growth trap" are discussed further below.

Novelty Over Familiarity

The fascination with something new in the stock market is as old as establishing stock exchanges. From the Tulip mania, when a flower became so important to investors for no practical reason, to the South Sea bubble, when the company promised to amass gold that exceeded the estimated amount of gold on the planet, to the more recent Tech bubble of 2000, when people paid exorbitant prices for technology stocks and earnings seemed to matter little—people believed that there is more to a business than the assets it owns or the profits it can potentially earn for Such excesses are on the horizon in the infrastructure and real estate sectors.

Time has repeatedly demonstrated that an enterprise is worth the amount of money it can generate for its owners in the form of distributable earnings over its estimated lifetime. Of course, it deviates to excessive levels during boom and bust, but this fundamental law remains constant.

During such times, people, in their quest for a piece of something new, overlook the inherent strength of time-tested familiar businesses, which will almost certainly continue to do business as they have in the past. Investing in something that has stood the test of time and has earnings to show for the price paid provides an opportunity for a contrarian investor to prosper at such times.

Growth or Financial Cancer

Expected growth is not a reliable indicator of a company's ability to create value. To understand the true impact of growth on a company's ability to create shareholder wealth, one must estimate how much cash is required to produce a unit of earnings growth.

Growth can only be considered value-accretive if it is greater than the cost of capital. Otherwise, it is deemed value-destructive, and growth is a negative factor in the value equation. So, whenever you see growth projections, remember to ask yourself, "How much capital does the business require to grow?"

Occasionally, the stock market participates in a fancy parade in which all that matters to participants is that particular industry will achieve a high growth rate in the future. They forget to ask about capital requirements, competition and the potential for a downward shift in the average ROCE earned by the industry, current expectations built into the stock price versus the growth expectations implied by the business, and so on. Failure to ask these questions will inevitably result in losses. When processing information, avoid mental shortcuts. Process all information and avoid being swayed by hearsay.

Recency Effect

Psychologists define the recency effect as a heuristic in which people tend to favour recent events because they are easier to recall.

At the top and bottom of stock market cycles, investors exhibit extreme forms of this bias. For example, just before a market crash, liquidity and optimism are at their peak among the investor community as a whole. During bear markets, on the other hand, the amount of capital invested in equities as a percentage of total household savings is at its lowest, indicating that people's propensity to defer their investments in equity markets outweighs the market's short-term underperformance.

The best time to buy a business for a rational investor who thinks about the company behind the stocks is when it is available at a deep discount to its value. That is not to say that predicting the bottom of a bear market is possible. Nevertheless, the long-term investing principle is put to the test, and one must be willing to wait patiently from the point of purchase until interest is renewed.

Key Takeaways

Investment opportunities do not come along every day. However, the market noise occasionally offers mispriced securities. All company information is always readily available. This can never give you an advantage when it comes to investing. Many people, however, believe it to be true. However, many investors are swayed by market noise, and their crowd behaviour provides opportunities to a rational investor. Being in control of one's impulses and urges will help one spot mispriced opportunities and avoid the growth trap. A growth stock has skyrocketed in value. It is always in retrospect. Nevertheless, the long-term investing principle is put to the test, and one must be willing to wait patiently from the point of purchase until interest is renewed.