Avoid Being Snared by Growth Traps With These 3 Red Flags

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I was flipping through television stations recently when I came upon an old Western film.

The story centered on some gunslinger and his noble quest for redemption.

It’s a common-enough scene from the turn of the century. But what caught my eye was the traveling salesman character — a man with flashy clothes and a booming voice claiming that the elixir in his hand will cure anything and everything.

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This “snake oil” trope is a familiar one, and not just because you’ve seen it on the big screen. Years later, Wall Street’s top investment houses would follow similar tactics, bilking fortunes from unsuspecting investors.

Though laws and regulations helped temper the problems, excess leverage and speculation continue to overtake the market from time to time.

In the 1990s, dot-com stocks left a trail of scorched earth as they screamed higher. Yet most didn’t generate any revenues, let alone profits, so it wasn’t much of a surprise when the bubble burst.

Looking at the market today, a new kind of speculation is forming around when a bottom will happen or if we have already reached one, with the idea that growth stocks have never looked so appealing.

But as our Health Indicator suggests, even if some growth stocks have fallen 30%, 40%, or even 50% over the last year, that doesn’t mean you should rush out and buy them.

It’s called the growth trap for a reason.

Stocks can always get a lot cheaper than they are now, especially ones that don’t have a lot going on “under the hood” when you do a close analysis.

The good news is that you don’t have to fall into a growth trap and lose your money… so long as you know these red flags to watch out for.

Growth Trap Red Flag No. 1: They Aren’t Original

The first sign that a company is a growth trap is it repackages an existing business without creating a competitive advantage.

Robinhood (HOOD) is the poster child of a poor business model. All it did was steal market share by selling a product below cost, forcing every other broker to give up profits to match its prices. Now, Robinhood has nothing to make it special.

Carvana (CVNA) is another great example. This company literally created a car vending machine so that customers could test-drive and purchase vehicles without interacting with another human being — and without having to pay the salaries of people who work in a traditional car dealership. When you stop and think about it, that’s pretty stupid. Sure, the gimmick is cool, but from a cost standpoint, the company needs to save enough on personnel costs to make money, which it doesn’t.

For the last decade, CNBC and the business world have hailed players such as Robinhood and Carvana as “disruptors.”

A better name would have been “thieves,” because many of these growth names simply stole market share.

Every single one of these companies found some temporary cost advantage or promotional point of differentiation and used that to sell products below cost in order to capture market share.

That’s why many of them have seen their shares obliterated in the last several months.

Now, there are some that sit in a gray area, such as Uber (UBER) and Netflix (NFLX).

These companies reinvented taxis and television, and they did bring key competitive edges to the table.

Uber’s software and gig-economy workforce unlocked a whole new set of efficiencies and labor in traditional logistics networks, and Netflix not only delivers original content but was one of the first to leverage internet streaming.

However, those advantages only took them so far, as both now struggle with market saturation. Netflix recently saw its subscribership decline for the first time in more than a decade, while Uber’s share of the U.S. market has tapered off to 69% since reaching 74% in September 2017.

Unless they continue to find ways to distinguish themselves from their competitors, these trends are unlikely to reverse in the long term.

Growth Trap Red Flag No. 2: Not Enough Cash to Pay the Bills

Companies go through three stages of profitability:

1. Generating cash from operations
2. Recording a profit on its P&L (profit and loss) statement
3. Generating free cash flow (operational cash minus capital expenditure)

They don’t always go in this order, but they do more often than not.

Businesses that can’t pay the bills can’t survive for long.

Any company that doesn’t generate cash from ongoing operations is in danger of bankruptcy. It can only borrow so much, and the more shares it issues, the more your holdings are diluted.

Robinhood, for example, hasn’t turned a profit since its IPO — most recently reporting a net loss of $392 million for the first quarter of 2022 — and has no free cash flow to speak of.

Companies that hit all three stages of profitability AND grow revenues are the ones to watch.

Now, there’s one more growth trap red flag you need to watch out for.

Growth Trap Red Flag No. 3: Slowing Growth

If the majority of a company’s value is predicated on growth, what do you think happens when that growth slows down?

It all depends on how strong a company’s fundamentals are.

Lower demand for products and waning interest in subscriptions, for example, is a bad sign — especially if a company doesn’t have particularly strong profit margins to begin with.

Meanwhile, a quarter with slower revenue growth is never favorable for a company’s near-term outlook. But while a mature, profitable company might be able to hold out and turn things around, that same circumstance could be a death knell for an up-and-coming business.

Faltering growth is the last thing that shareholders want to see. And if a company has feeble fundamentals, what might otherwise be a minor bump in the road can easily turn into a major long-term drawdown.

The Bottom Line

Growth costs money. With interest rates on the rise, that cost is even higher.

Don’t be fooled into thinking that just because Peloton trades below $10 it’s a steal. Remember, many of the dot-com companies went bankrupt.

I don’t know that we’ll see such widespread destruction. But I wouldn’t be surprised if some of these growth trap companies aren’t around in a year or two.

Rather than getting myself in trouble trying to pick the bottom, I’ll wait until I get a clear signal from a backtested system that I have faith in — like TradeSmith Finance’s market health indicators.

Our market health indicators factor in key “under the hood” metrics like a stock’s Volatility Quotient (VQ%) to show you, at a glance, how healthy an opportunity is so you can make data-driven decisions.

Let me give you one last piece of advice before you go: If you get that urge to buy a stock in a downtrend, send me an email. Explain why you like the stock and what makes it a buy at that price.

You’ll often find that just the act of writing out the justification can help you stay out of trouble.