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Equity Perspectives

While fundamentals are the critical guideposts in growth investing, astute technical analysis can signal the right time to buy and sell.

In keeping with our rigorous research discipline, fundamental analysis is the foundation of our investment process, helping us to identify transformative companies whose growth potential is underestimated by the market. We assess the return and risk potential posed by each company, scrutinizing its business model, management, industry health, and competitive advantage. We look for these factors combined to generate revenue and earnings growth that drives excess stock performance.

High-growth companies have big potential and much greater risk, and the allure of a “multi-bagger” growth stock gives rise to greed, while the prospect of a harrowing decline instills fear. Since these and other behavioral biases and emotions run rampant in the high-growth universe, growth companies’ share prices often will vary substantially from their fundamental progress. But ignoring this human behavioral element would be, in our view, a big mistake, which is why we use technical analysis to understand it. We believe combining fundamental and technical analysis helps us to better exploit the return potential of growth stocks and to manage the risks they pose.

Behavioral Biases in Growth Stocks
Behavioral biases are on full display in the high-growth company universe. Particularly pernicious are anchoring and extrapolation. The anchoring bias occurs when investors rely too heavily on prior estimates of value, underestimating the improvement or deterioration of a growth company’s fundamentals. Extrapolation leads people to overreact to perceived trends. Many growth companies seek to capitalize on new trends—if the magnitude or timing of the trend is overestimated, or if the company itself is not a good vehicle to participate in the trend, then that’s a problem. These emotions and biases contribute to growth-stock volatility.

Open Table, the website for restaurants, is an interesting example of how prices for a high-growth company can diverge dramatically from fundamentals. (See Chart 1.) The company’s shares went up six-fold in 18 months following its 2009 initial public offering (IPO), then fell by 70%, before rising again four-fold, after which it was acquired in 2014. Over this time period, fundamental progress occurred at a far more measured pace. Although there were both positive and negative fundamental inflection points that triggered the changes in stock price, these share-price movements were far more pronounced than would be expected by the fundamental changes alone.

 

Chart 1. Momentum Is a Powerful Factor and Can Diverge from Fundamentals
Stock price, net income, and sales for Open Table, 2009–14.   


Source: FactSet.
The above data are for illustrative purposes only and are not meant to represent the characteristics of an actual portfolio managed by Lord Abbett or any particular investment.  Neither do they constitute a recommendation or investment advice, and should not be used as the basis for any investment decision.  Data as of 12/31/2014.  Open Table was acquired in 2014.

 

A fundamental research-only approach typically would ignore this significant stock volatility. Combining fundamental research with technical analysis argued for greater exposure during the ascent, and less during the descent. The fundamental context provided the evidence. The sales and earnings growth acceleration in late 2009 set off the animal spirits, as investors imagined the company’s potential. Greed took hold, and the shares went on a tear. As this was happening, the forces that would create a reversal—such as the sheer magnitude of the stock’s relative outperformance, the increasingly stretched valuation, and the catching up of consensus estimates to the actual growth of the company—were building. When the CEO transitioned to chairman, it was a sign that the money had been made and the selling began. Fear took hold as the stock slid 70%. Thereafter, a more normal trading pattern set in, leading to the company’s acquisition.

Technical Analysis: The Footprint of Behavioral Biases 
We use technical analysis to help us recognize these behavioral biases that are prevalent in high-growth stocks. Many aspects of technical analysis are useful in this endeavor, though the most important is momentum—the phenomenon by which prior price action is predictive of future prices. The existence of momentum is a well-established empirical fact. According to a wide range of academic studies, for example, the return premium is evident in more than 200 years of U.S. equity data, as well as in other countries and across other asset classes. Some of this evidence suggests that the momentum premium has been a part of markets for as long as there have been markets.1 Chart 2 illustrates the momentum anomaly over the period 1927–2015.

 

Chart 2. The Momentum Premium Has Existed for Decades
“Winners” and “losers” versus the market,* 1927–2015

The above returns are for illustrative purposes only and not based on a portfolio Lord Abbett manages. The data are from Dartmouth business school professor Kenneth French’s data library and stretch from 1927-2015.  

* The “market” is defined by the widely cited analysis of Fama/French benchmark portfolios. To find winners and losers, the database for momentum stocks has been sorted by decile. “Winners” represent an average of the top 50% of decile returns and “losers” represent the average return of the bottom 50% of decile returns.  Hypothetical portfolios are unmanaged, are not investable, and returns are for illustrative purposes only, and do not reflect any management fees, transaction costs or expenses. According to the Fama French website, the momentum and short term reversal portfolios are reconstituted monthly and the other research portfolios are reconstituted annually. They reconstruct the full history of returns each month when they update the portfolios. (Historical returns can change, for example, if the Center for Research in Security Prices (at the University of Chicago's Booth School of Business) revises its database. Although the portfolios include all NYSE, AMEX, and NASDAQ firms with the necessary data, the breakpoints use only NYSE firms.

 

Momentum has two dimensions: absolute and relative momentum. Absolute momentum compares a stock’s price performance with its past performance, while relative momentum compares its price performance with other stocks. Both absolute and relative momentum may enhance returns, but combining them may provide better results. Table 1 illustrates this finding. Accordingly, we use both. Stock picking is an absolute and relative endeavor.

 

Table 1. Combining Absolute and Relative Momentum Historically Has Been Optimal 
Composite portfolios,2 1974–2011

Source: Gary Antonacci, “Risk Premia Harvesting Through Dual Momentum,” Portfolio Management Associates, 2012.
The information shown is for illustrative purposes only and  does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or a guarantee of future results.

 

This evidence of momentum is impressive, if not eye-popping. Given the prevalence of greed and fear in growth stocks, it is no surprise that momentum is particularly evident in high-growth stocks. Properly applied, we believe momentum helps us to ride our winners as long as possible (well beyond what valuation would have us do), and to cut our losses quickly (many times well before business momentum slows and while the stock appears to be cheap).

Applying Technical Analysis to Growth Stocks
When we apply technical analysis to growth stocks, it is always with consideration of the fundamental context. Being as accurate as possible regarding the fundamental progress and outlook of a company is, in our view, critical to using technical analysis appropriately. It also is important to be objective, so that human biases and/or illusions do not arbitrarily overrule or ignore the technical evidence. The point of using technicals is to help achieve a better outcome than can be had through fundamental information alone.

Many times the change in momentum is sudden and powerful, as often times positive momentum will sow the seeds for the negative momentum that follows it. Rather than dissipating, positive momentum sometimes retains its full force as its turns negative. This can lead to momentum crashes. The key is to anticipate when momentum has shifted or is about to turn. We seek out and aim to stay with strong momentum stocks, but when formerly strong momentum stocks peak or fall, we aim to take down positions or exit. The process of cutting losses and holding profits is a tax-efficient deferral; however, selling a formerly up-trending stock that has broken down and paying taxes is better than holding and incurring greater losses.

Although we believe that the evidence and persistence of momentum is compelling, we want to stress that it is simply an important part of the process (versus the process itself). Fundamental research is the foundation of the process, and technical analysis, portfolio construction (including diversification and position sizing), and risk management are all important tools.

The Momentum Anomaly in Action
Momentum expresses itself in individual stocks and sectors. Many times, the reason for the change in momentum only becomes clear after the fact. And for those who suggest that there is no warning of momentum crashes, we disagree. Momentum’s “smoke” usually precedes its “fire.”  

Technical Analysis at the Sector Level
The biotech industry got a huge boost from the mapping of the human genome shortly after the turn of the 21st century. Its impact on cancer therapies and patient longevity has been profound. Until the 1960s, people didn’t live long enough to make it prevalent enough to call it a disease. Over time, scientists discovered genetic mutations were the culprit. This led to a race to map the human genome, so that we could develop much more accurate and less harmful drugs to attack cancer. By the year 2005, one biotech company had significantly reduced the cost of the genomic information, setting off a boom in new biotech drugs.

When a new industry like modern-day biotech arises with great potential, it sets the stage for extrapolation bias in which the trend is over-estimated. Caution is thrown to the wind. Although biotech drug discovery is exceedingly risky, new drugs are described as part of a “pipeline” (the connotation being one of little, if any, risk). These developments triggered the greed that led to a massive four-fold increase in biotech stock prices between 2011 and 2015. A number of the stocks went up much more.

In August 2015, a negative tweet from a U.S. presidential candidate about pricing for these drugs triggered a sell-off. Over the next nine months, biotech shares fell 50%. This price action could be seen on a stock-by-stock basis, and thereby alerted investors to the wider (sector) phenomenon. Only after the aforementioned tweet did it become evident that the forces of negative momentum (valuations in the sector got extremely stretched) had been building. Then, during the remainder of 2016, the stocks went sideways for one more year. At the beginning of 2017, a new bull market started, and for the moment seems to still be intact.

Applying Technicals to Stocks
We believe that as far as growth stocks are concerned, momentum’s smoke usually precedes and foretells of its forthcoming fire. Following are two examples where positive and negative momentum came knocking, and in which the fire that followed was far more impactful than the original smoke.

A few years ago, a social media giant made a successful transition from the desktop to mobile computing, leading to a surprising acceleration of growth. The stock instantly rose by 20% following a quarterly report that showed the progress of mobile. Should investors have taken profits? No; many bought more shares ahead of what would be a 500% move up in the stock over the next four years.

Transitioning successfully to mobile computing from the computer desktop was a big deal. Smartphones, for example, had moved a huge share of communications to the mobile world. Younger people, who represent most of the future growth, use mobile to a much greater degree. Opening up this new avenue meant a much larger growth opportunity. The initial move up was the precursor to a much larger gain. The shares ascended over the next four years because of investors’ “anchoring bias”— that is, the initial impression of the fundamental prospects was well below what it would turn out to be.

More Food for Thought
Last decade, an exciting new restaurant concept debuted with an IPO priced at $22 per share. The name became a stock market darling with a hefty valuation, rising to $758 per share over the next several years. Then, a food-related sickness at one of its stores precipitated a 15% price drop. Did it make sense to buy because the stock had become cheaper? No, some investors opted to get out before the 57% plunge that would ensue.  

After a substantial bull market, a food scare is a serious matter for a restaurant that the stock market loves. The significant price gain was driven by the belief that the food offering was delicious and healthy; the cleanliness of it was a given. So, it was a very meaningful fundamental change, when it first became evident that the restaurant chain was not as wholesome as commonly believed. This set the stage for a nasty multiyear momentum reversal. Only after the fact did it become evident that the forces of negative momentum—including a lack of cleanliness—had been building. And why did the stock go down for two straight years, instead of all at once? Possibly because of the anchoring bias that led some investors to fight the bad stock-price momentum due to their reliance on prior estimates of value (which were no longer valid).

Managing Greed and Fear
Our investment process is premised on the view that the market persistently underestimates the return potential of high-growth stocks. This is partly a sign of the times, because the technology revolution is enabling innovation to proceed at a rapid pace. The most innovative companies tend to be growing at a significantly faster rate than the general economy, and, therefore, have the business momentum that can translate into persistent stock-price momentum.

But an attempt to exploit this superior return potential is accompanied by greater risk, so a fundamental research investment process must be reinforced with other tools. Using technical analysis to identify momentum—absolute and relative, positive and negative—is one way to make the fundamental process more effective. The key is to apply technical analysis properly and consistently to our investment process. We lean toward owning strong momentum stocks. When strong momentum arrives, we are inclined to add exposure; when formerly strong momentum peaks or fails, we are inclined to reduce or exit positions.

 

1 Cliff Asness, Andrea Frazzini, Ronen Israel, and Tobias Moskowitz, “Fact, Fiction and Momentum Investing,” The Journal of Portfolio Management, September 23, 2014.

2 Composite equities used in the Antonacci study used the MSCI US, MSCI EAFE, and MSCI ACWI ex US indices. These are free float adjusted market capitalization weightings of large and midcap stocks. The MSCI EAFE Europe, Australia and Far East Index includes twenty-two major developed market countries, excluding the U.S. and Canada. The MSCI ACWI ex US, i.e., MSCI All Country World Index ex US, includes twenty-three developed market countries and twenty-one emerging market countries. MSCI ACWI ex US data begins in January 1988. Antonacci team created a composite data series called EAFE+ that is comprised of the MSCI EAFE Index until December 1987 and the MSCI ACWI ex US after its formation in December 1987.

The Sharpe ratio was developed by Nobel laureate William F. Sharpe as a measure of risk-adjusted performance. It is calculated by taking an asset class’s (or portfolio’s) excess return above the risk-free rate and dividing it by the standard deviation of its returns. The greater the Sharpe ratio, the better the risk-adjusted performance has been.

Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Annualized Return: A measure of investment performance that allows comparisons between different time periods. Cumulative Return: The total change in the value of an asset or a portfolio over a given period of time, expressed in percentage terms. Often displayed as the growth of a given sum of money over the time period.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity.   If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The examples provided are hypothetical, are for illustrative purposes only, and are not indicative of any particular investor situation.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies, including market, liquidity, currency, and political risks.  Investments in growth companies can be more sensitive to the company’s earnings and more volatile than the stock market in general.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments involve risk, including possible loss of principal. No investing strategy can overcome all market volatility or guarantee future results.

The opinions provided in this posting contains the current opinions of the author are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This commentary is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This commentary is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

ABOUT THE AUTHORS

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