Will growth stocks outperform once again?

Global growth stocks enjoyed a golden period in recent years. This continued throughout the pandemic as lifestyles (and spending habits) quickly adjusted to new ways of living.

Low interest rates and business innovation led to a surge of investor interest in the shares of well managed global companies with prospects of long-term earnings growth.

Yet the start of 2022 brought a reversal in the relative fortunes of both growth and value stocks. Higher interest rates raised companies’ variable borrowing costs which impacted profits. Higher long-term interest rates also increase the equity discount rate of companies, which reduce the present value of future earnings and dividends – and hence the market value.

This impacted the valuations of growth stocks – which depend on growing profits that will be made further out in the future – more than value stocks. These latter businesses – such as mining, energy, banking and consumer staples companies – tend to deliver more immediate and predictable earnings.

Growth stocks to roar back?

There are sound reasons why many high-quality growth stocks are expected to perform relatively strongly in the next phase of the economic cycle.

The indiscriminate sell-off in growth companies this year has extended beyond those with little or no cash flow and dubious business models. Quality growth stocks across the board have underperformed value stocks, leaving some great companies priced at more attractive valuation levels. This implies higher potential returns over the medium-to-long term.

Moreover, growth stocks are positioned to benefit from longer-term secular trends which remain intact in the post-COVID world:

• Working from home is here to stay. This brings growth opportunities for a wide range of disruptive businesses as people continue to work and shop at home, whilst consuming media, entertainment and dinner ‘from the couch’.
• The decarbonisation of the global economy is now irrevocably underway, accelerated by the US Inflation Reduction Act. The war in Ukraine may lead to higher fossil fuel prices and more coal production, but only in the shorter-term. Decarbonisation benefits companies in a range of sectors (e.g. electric vehicles, green project finance and renewable energy technology) that enjoy low sensitivity to the business cycle.
• The trend for affluent professionals to delay starting families is expected to continue throughout the downturn. This will support secular growth in the demand for luxury goods and other consumer discretionary spending, much of which is supported by the resumption of leisure travel.

Value investing may only take you so far:

• The good news is now likely fully ‘baked into’ current share prices. Continued outperformance of value stocks would require sustained outperformance in big sectors such as energy and financials.
• Energy has certainly been enjoying strong cash flows in recent times. However, share prices now reflect this, existing supply is already being expanded, and new supply will be added over the medium term. Eventually, either prices will fall, or windfall taxes will likely be imposed – as seen recently in Queensland and the UK.
• Banking is set to be affected by higher interest rates. The banking sector is likely to face a slowing housing market with less new mortgage business. Over time the impact of rising bad debts will further offset the benefit to banks of wider lending margins, which is brought by higher interest rates.
• Not all corporate earnings are cyclical. A likely decline in household and corporate spending will have a direct impact upon company profits, yet not all growth stocks are cyclical. Growth companies in healthcare, pharmaceuticals, property management and agricultural technology are largely protected from any such fall in spending.

Capturing investment returns in the next phase of the market

Continued outperformance by value stocks should not be assumed. Growth stocks are now more attractively valued, will continue to benefit from long-term trends, don’t rely on rising spending and do not face the challenges of the current ‘hot’ value sectors.

Quality growth stocks provide opportunities to capture long-term sustainable earnings growth. So whilst the economic cycle should be considered carefully, simply waiting for the downturn to pass may impact returns.

Investors with a long-term horizon and a willingness to disregard shorter-term market volatility stand to benefit from an exposure to high quality innovative global companies able to grow earnings over time.