This question is often posed in wall street circles and among the millions of investors throughout the world, should high growth stocks be bought going into and/or during recessions? There are two schools of thought for this issue, which I would like to go over, and then after going over those thoughts I'll provide my opinion on this question.
The first school of thought says that high growth stocks should be bought because investors will continually be looking for growth and there will be fewer and fewer areas to find such growth. People who believe this is a good plan will tell you that high growth stocks generally hold up better than the overall market and can actually serve as a little bit of a save haven.
The second school of thought says that high growth stocks should be sold going into a recession because they are the most at risk for large losses during the market selloff that is caused by the recession. These stocks have usually gained a large amount in the past year or two and are more "ripe" for a selloff.
So how does it really work? What should you do with high growth stocks going into a recession? Generally when the market starts losing ground going into a recession the highest of growth stocks hold up fairly well. The highest of growth of stocks are usually the last to fall when the market is in the process of bottoming out. The problem here is that when they do fall, they generally fall very hard, with even very large companies falling as much as 20 or 25% in a week. This is generally a sign of the market succumbing to the pressure that all stocks should be sold at that time, not just the worst performers.
Should you buy growth stocks in recessions and hope to outperform? I think for the majority of people this is a dangerous propisition. More often than not the individual investor will buy into a high growth stock, only to see the bottom fall out when the market is bottoming, and sell out of their position. In reality when the first signs start to emerge that the economy could be rebounded, that is the best time to buy high growth stocks since they should benefit more than the average stocks.
Buyer beware when trying to navigate the waters of recession by buying high growth names.
This is sort of in direct opposition to my current portfolio holdings (it seems that the severity of the recent downturn in the markets has locked me into several of my positions), but I totally agree that growth stocks should be avoided when a recession or slowdown looms. This is not because I don't believe that growth stocks offer good potential, but more because growth stocks are most likely to suffer from premium contraction as investors become less willing to pay for growth. This means that even if a growth stock is able to keep pumping its profits up, multiple contraction will suppress growth in valuation. A great example of this is J. Crew which, thus far (and keep your fingers crossed for the upcoming earnings report), has managed to continue to execute and drive earnings growth. Despite this, the stock has languished in the low 40s for most of the year while its P/E has fallen from the mid-30s to the low-20s. But, my belief is that if you find a growth stock which has the right operational strategy and a strong enough fundamental business (market leading companies), that these will be the stocks which rebound most swiftly as the economy inevitably turns around. Thus, with a long enough investment horizon, the right growth stocks still represent strong investments. A good example of this might be Google, a growth company by definition but with strong enough fundamentals such that one can reasonably project to maintain market leadership well into the next decade despite any hitches in near-term revenue/profit potential. (Disclosure: I am long both stocks mentioned in this comment)
Posted by: Dan | March 9, 2008 4:58 PM | Permalink to Comment