Has the sell-off created an opportunity in growth stocks?
There are plenty of growth companies that will continue to exhibit robust and durable profitability, and those names that look set to exceed expectations are particularly attractive.
Chief Market Strategist, Asia Pacific
- Rising rates are challenging growth stocks with high valuations, although many companies’ fundamentals are still in good shape
- Growth companies can exist in a broad range of sectors, not just in technology
- Investors need active management to seek companies with strong earnings outlook and ability to adapt to new environment
2022 has seen a volatile start, with many of the growth names that performed well in the initial stages of the pandemic—as well as over the prior cycle—under pressure. The Federal Reserve’s abrupt, hawkish shift at the beginning of the year sparked a sharp move higher in interest rates and rate expectations, in turn leading valuation multiples to compress. As a result, and despite a late quarter bounce, much of the index experienced a meaningful pull back and the Russell 1000 Growth index closed the first quarter down 9%.
Large, high-growth companies were at the center of the storm, as they came into the year looking expensive and carrying high expectations. This was evident in valuation spreads, which rose to historical highs; with rates expected to rise further this year, caution in this part of the market continues to be warranted. Outside of these high-flyers, however, we have seen a significant reset in valuations against a backdrop where fundamentals have largely remained intact. In fact, approximately two-thirds of the companies in the Russell 1000 Growth Index have seen consensus sales and earnings estimates maintained or increased for FY2023 and FY2024. With that said, being selective and mindful of position sizing is critical as valuation risk remains.
Furthermore, investing in growth does not mean allocating to a specific group of sectors in a way that resembles the benchmark. Despite what headlines may suggest, the growth universe is far broader than the high-flyers that tend to get the most time in the spotlight. There are plenty of growth companies that will continue to exhibit robust and durable profitability, and those names that look set to exceed expectations are particularly attractive. These companies exist across a variety of sectors including financials, industrials, consumer and, more recently, health care. Importantly, these companies are utilizing technology to enable their next leg of growth.
Exhibit 1: Trailing 12-months earnings per share
Indexed, 12/31/2002 = 100
The decision to look for entry points in investing in growth sector depends on investors’ financial objectives. For those with a longer investment horizon, say two to five years, the growth sector has a track record of delivering strong performance. Unsurprisingly, this comes from long term earnings growth outperforming the broader market and the value sector, as shown by Exhibit 1.
In the near term, there are some challenges, such as rising risk-free rates impacting stocks with more extended valuations, or those companies with poor earnings outlook. With rising rates, investors could be less patient with companies that have yet to turn a profit.
We have often written about the idea of owning growth and renting value. Ultimately, the long-term forces of innovation and structural change are alive, and a dedicated allocation to growth stocks will be necessary to benefit from these trends. However, in a world characterized by a variety of crosscurrents, prudent risk management will remain as a key determinant of investor success.
It is also important to recognize that the field of technology is always changing, and disruption is a constant. Active investors need to understand a company’s strategy in adopting to a changing world. There are also developing trends that would drive the future of the growth sector. This is not limited to exciting new phenomenon such as blockchain technology or metaverse.
One example is renewable energy. The crisis in Ukraine has focused the minds of European policy makers the need to accelerate renewable energy adoption. This transition is no longer just to reduce greenhouse gas emission and address global warming, but now it has an added significance in improving energy security and reduce economies’ sensitivity towards fossil fuel prices.