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Written by: Richard Penny
Richard Penny, fund manager of the L&G UK Alpha and UK Special Situations Trusts, argues hype does not always translate into returns and explains why investors are better off avoiding early stage growth companies.

I am no stranger to the hype which can surround certain stocks and sectors. As a manager of a technology fund back in the 1990s, it was impossible not to be attracted to all the “new paradigm” growth stories that were being touted by the various companies we would meet.

However, as both myself and the investing community found out, being early into new technology stocks does not always end well. In short, hype rarely translates into investment returns and 10 years into managing the L&G UK Alpha Trust one of my main conclusions is that you are better off avoiding early stage technology companies.

For example, take a look at the robotics sector, which is receiving a lot of attention at the moment. In years to come the sector may present a number of opportunities, but at present using Gartner’s “Hype Cycle” I would argue such companies are at the ‘peak of inflated expectations stage’. This means that early publicity of said companies has produced a number of seemingly successful but unproven stories, leading to possible fund launches and ‘hot’ money coming seeking an investment opportunity.

However, what often follows this stage is what is called ‘the trough of disappointment’, in which interest wanes and the producers of the technology shake out, or fail. It’s what happened during the TMT bubble and is a pattern which always tends to persist leading to a rollercoaster ride that is played out in the equity market over and over again.

The right innovation is not always enough as an investor. A wider perception of commercial application is needed and timing to market can determine investment success. In the short term confidence can often be misplaced or fail to appreciate the challenge to monetise developments.

Instead, I prefer the ‘goldilocks approach’ to investing. For example, we avoid biotech stocks in the fund as they are too early in their development; the porridge is too hot. Meanwhile we don’t like the big pharmaceutical stocks which have large headwinds and are basically over the hill; the porridge is too cold. The sweet spot – the just right oats – is somewhere in between and we have had great success in the portfolio in a couple of healthcare diagnostic stocks for example.

The problem is paying up for growth expecting a rapid turnaround time for product launches which may be slower to deploy than anticipated weighs on returns. It doesn’t necessarily have to be that way though. For example, Microsoft was profitable three years before IPO meaning it is not necessary to punt on ideas versus proven businesses.

Of course the internet and mobile communications have transformed our lives. Looking forward there is no dearth of opportunities. However, from an investor’s point of view when, where and how profits will be generated will have less to do with “the new” and more to do with tried and tested indicators of success – namely, strong and sustainable cash-flows, realistic valuations and organic, self-sustaining growth.

Richard Penny is manager of the L&G UK Alpha and UK Special Situations Trusts

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