For many investors, nothing captures their imagination like growth stocks, especially those of companies that disrupt the established order with transformative innovation the world has never seen before, or simply products, services, or technologies that are faster, better, and cheaper.
No matter how slow an economy gets, history shows that there are always growth leaders. Many of them have become household names. At certain inflection points in their history, their valuations were considered high, but relative to what they were about to create for their respective industries, and even society as a whole, they turned out to be dirt cheap and buys of a lifetime.
But for all the glamour around such successes, there can be a dark side within the high-growth universe, as evidenced by the occasional posers, false hopes, and Ponzi schemes that propel 24-hour news cycles. These are companies that professional managers look out for and strive to avoid (but sometimes can’t early on), which brings to mind the recent, wild trajectory of Valeant Pharmaceuticals. We don’t know yet whether Valeant is the long-term transformational company that a handful of hedge fund managers believe it is, or whether it is similar to other companies that imploded in years past. But one thing we do know, putting fundamentals aside, is that there were some loud and clear signals based on technical analysis1 of Valeant’s stock that some investors did not heed prior to its recent dive.
In contrast to the feverish speculation of the dot-com era around early 2000, for example, technical analysis has gained stature in recent years as a reliable and effective discipline for both risk management and for driving upside potential for growth managers. Technicals, in our opinion, provide a sound framework for evaluating a stock when investor sentiment and behavioral biases play a significant role. When valuations and growth expectations are high, sentiment plays a much more notable role than it does in the value space.
As for the unfolding Valeant story, a lesson for investors goes beyond just one stock. In fact, we see this type of flameout on a regular basis in the high-growth space. In our view, technical factors (a key focus of Vernon Bice, Lord Abbett Portfolio Manager) would have alerted an active manager to cut holdings of this stock last summer when the stock broke below its 50-day moving average on August 20 and 150-day moving average on August 24. The price went from $263 on August 6 to $200 on August 24. The signal to completely sell out of the stock came in September, when the stock failed to hold above its 50-day moving average on September 21 and then fell through its 200-day moving average on September 25, said Bice, citing WONDA price data.
As the stock price plunged through year-end, the temptation for those who ignore technicals was to hold on vehemently—or even buy more—because the stock appeared to be cheap. This rationale is a behavioral bias known as the “gambler’s fallacy,” which essentially says that after a losing streak, we are due for a positive event. If a manager takes this approach, they become a gambler rather than a market practitioner, and, hence, contribute to, rather than take advantage of, the irrationality of market participants. All too often, the reality is the opposite phenomenon: When you have a technical breakdown in a stock, accompanied by unraveling fundamentals, the fall can look a lot like Valeant’s.
As for the fundamentals around Valeant stock’s swoon, Tom O’Halloran, Lord Abbett Partner & Portfolio Manager, who oversees several growth strategies, commented recently that “organic growth is superior to acquisition-driven growth, especially when the acquirer cuts out the heart of the acquired companies. And although such manufactured growth can fool the market for a while, when the market figures out the falsehood, listen to the market, and get out!”
The takeaway for growth investors is clear: the high-growth universe is full of big winners and big pretenders. Growth stocks may be somewhat efficient over the very, very long term, but they can be wildly inefficient in the short and medium term, and investors can get burned badly by that inefficiency, as even the world’s best growth investors can attest. The remedy is not to be stubborn when the market is telling you that it’s time to move on but rather it is an imperative for an investor to be active, to adapt, to listen to the market, and to use technical analysis as a complement to fundamentals. When the market tells you a sell-off is coming, as it does frequently if you know where to look, getting out and moving on enhances one’s chances of success, and long-term portfolio growth, as much as picking the right stock and riding it higher.
The opportunity for active managers is to incorporate fundamental research to know which companies are truly transformational and technical analysis to know when to own them and when to move on. Indeed, the challenge for active managers has been coming up with the right mix of stable, cyclical, defensive, and aggressive growth companies, and assessing how long they can sustain their success. We view being active and using technicals as essential to getting this right.
Brian Foerster is equity strategist at Lord Abbett