PM Corner: In conversation with Giri Devulapally
Growth stocks have been at the epicenter of market volatility, but we still see opportunities over the long term
We have seen a lot of market volatility thus far in 2022, and the growth side of the style box has been at the center of the action. What’s the view from your vantage point?
After a multi-year run of outperformance, growth stocks have been at the epicenter of market volatility. The Federal Reserve’s abrupt shift to quantitative tightening sparked a sharp move higher in rates (and future rate expectations), which in turn caused valuation multiples to compress.
When the year began, large high-growth companies were expensive and carried high expectations. This was evident in valuation spreads, which had risen to historical highs. We continue to exercise caution in this cohort of stocks – either by selling them outright or by managing risk through careful sizing of positions.
The market continues to grapple with the implications of supply chain disruptions and inflationary pressures. It has been a tough period in absolute terms. Looking simply at returns we can see that most sectors are down year-to-date in the benchmark, with defensives/energy faring better on a relative basis.
How have company fundamentals played out so far in 2022? Are you seeing anything that substantiates the price action?
We have seen a significant reset in valuations against a backdrop where fundamentals have largely remained intact. Most companies in the portfolio have reported first quarter earnings results. They have been fairly typical, with 72% of companies beating consensus revenue estimates and 70% beating on earnings. The market has been very unforgiving of companies that have missed expectations or provided negative guidance, regardless of sector.
At a high level, how do you approach growth investing?
Put simply, we want to invest in companies that have the ability to deliver higher growth than market expectations over the next three to five years. In our view, great growth stocks possess three key characteristics:
A large addressable market undergoing meaningful change
Sustainable competitive advantages and strong execution
Good price momentum
We believe the market embodies a greater wisdom, except at extremes. We want to harness that wisdom in our investment process because stocks can go up before they go up a lot more, and the opposite can be true as well.
Momentum embeds humility into our process. We recognize that we can be wrong, and if the market is telling us that we might be missing something (e.g. momentum is fading), we try not to be dogmatic and will reduce or eliminate a position.
Within our strategy, we also try to manage a few key risks. We do this by focusing on capturing the big winners while mitigating the impact from underperformers.
Consistent with our process, we continue to shift to where we see the widest disconnects between fundamentals and expectations.
Let’s talk about the shape of the portfolio – what does it look like today?
Consistent with our process, we continue to shift to where we see the widest disconnects between fundamentals and expectations. We continue to be cautious where expectations remain high, most notably in long duration, high multiple growth stocks. Throughout last year and into 2022, we have been generally reducing our positions in this cohort to manage risk. This has occurred either modestly, if we continue to believe in the long-term fundamentals of a given company, or more expeditiously, if conviction has waned.
From a sector view, technology and consumer discretionary remain notable underweights. We continue to be overweight financials and have grown increasingly positive on health care (specifically bio-pharma and distributors).
Tell us more about the higher conviction positions in the portfolio.
We are staying open minded and taking an agnostic approach as to where new growth ideas can come from. Currently, we are finding opportunity in franchises that benefit from durable earnings growth and strong free cash flow and those that are poised to exceed more modest expectations.
Case in point: McKesson, a leading pharmaceutical distributor. We initially bought the stock in April 2020 and kept the position small until recently, when we began scaling it up. Long out of favor, pharmaceutical companies have continued to invest meaningfully in R&D and their pipelines are about to bear fruit. Specialty drugs, which often require special handling expertise, are taking an increasing share of overall drug portfolios, and this translates to revenue upside for distributors. McKesson’s fundamentals are poised to benefit against this backdrop, and we believe it can exceed growth expectations.
AutoZone is another example. The auto parts retailer continues to gain share in the “do it for me” segment. Local mechanics rely heavily on parts from AutoZone due to its rapid delivery times. In the “do it yourself” segment, a rebound in miles driven coupled with a tight new/used car market is boosting demand for auto parts. We think AutoZone’s business has durable growth, strong pricing power and an attractive valuation.
Elsewhere, companies across numerous industries are utilizing technology to enable their next leg of growth. Deere, a top overweight in the portfolio, is a prime example. Its precision agriculture technology makes it uniquely positioned to capitalize on the next big increase in farmer productivity. The company leverages massive data sets, using AI to drive automation in its equipment. Its “See & Spray” technology allows equipment to target specific weeds only, reducing herbicide use. Additionally, new planters double planting speeds, which greatly reduces fuel costs. We foresee further share gains, improving pricing power and profitability.
The companies mentioned herein are shown for illustrative purposes only. Their inclusion should not be interpreted as a recommendation to buy or sell and is in no way an endorsement for J.P.Morgan Asset Management investment management services.