Many portfolios were given a value tilt in 2022 in response to a dim outlook for growth stocks, but a surprise market rally this year has investors finding strong, selective opportunities among growth companies, according to portfolio managers at Capital Group.
Cheryl Frank, an equity portfolio manager in the firm’s San Francisco office, said peak inflation in the middle of last summer, the market drop-off and the Fed’s response worked together to compress market valuations through October 2022 and set the stage for a rally.
“So this year the S&P is up 8%, the Russell 1000 Growth is up 18%, and growth stocks this year have had a really big rebound,” she said yesterday during a virtual discussion of where growth investing is headed. “The rally here can continue if the consumer stays healthy and inflation continues to abate. For now, a downward direction of inflation is positive, because we don’t know where it will settle. At some point it may become clear that inflation will not settle at the 2% target, which could increase long-term rates and pressure market valuations again.”
As the Fed seeks equilibrium with inflation, the yield curve remains inverted, which is a signal that the bond market is anticipating a recession, she said. Add in the debt ceiling debates and the turmoil in the banking sector, and Frank had one word to describe the investing climate: choppy.
Mark Casey, another equity portfolio manager in the San Francisco office, said in investing environments like this one he always remembers that “it’s not a stock market, it’s a market of stocks.”
“The stock market is the sum of all the stocks, and they have different prospects,” he said.
For example, at the end of 2022, a lot of people thought the U.S. was going to enter a recession in 2023, and that’s still the consensus, he said, adding that in a recession, advertising tends to drop precipitously, even further than the economy shrinks.
“Advertising right now is really bad for the cable network companies. But Netflix, which never had it before, is adding advertising and it seems to be helping the earnings estimates rise there,” he said. “So even in the context of a choppy forest, you still have to look at trees one by one and make your best judgement as to how attractive they are.”
Over the last decade, growth was driven by a narrow set of companies and industries—mostly tech and tech-adjacent—but that’s changing, Frank and Casey said.
The portfolio managers identified four significant shifts that affect the kinds of companies they’re looking for: interest rates moved from very low to much higher; companies that make intangible products are being edged out by those with physical assets; reshoring supply chains is a future-forward strategy coming out of the exposed weakness of global supply chains during the pandemic; and narrow equity leadership is being replaced by broad equity leadership.
“The biggest change around this next phase of growth investing is that we’re investing in a higher-interest rate environment,” Frank said. “If you go back the last 20 years, we were in a steadily falling interest rate environment, which meant that capital became easier and easier to access and at lower and lower cost.”
Companies were comfortable taking large amounts of risk because they had the ability to do that and keep accessing the capital markets, she said. However, expensive capital favors “bigger, more profitable companies over young, money-losing start-ups.” And there’s less tolerance for long periods of capital loss.
The pricing power of large companies has also made some more mature companies look more attractive to growth investors.
“Right now, if you are a large profitable company and you have an upstart competitor that was losing a lot of money and might not be profitable for another couple of years, a strong balance sheet is a real advantage,” she said, adding that an acquisition would then give the larger company a growth boost.
According to Casey, some 60% of the stock market decline in 2022 was driven by seven or eight mega-cap tech companies. And 2023 doesn’t seem all that different in terms of the narrow concentration of the highest-weighted companies.
“The market’s still pretty narrow, concentrated around this relatively small number of companies. But I don’t think we’re seeing a return to the mania of 2020 and 2021. What we had then was a very broad euphoria around certain themes. Just about every company that was involved in software as a service was a great stock. Every company that was involved in electric vehicles was a great stock.”
Ditto for any company the “Wall Street bets community on Reddit” got behind, and every crypto project, he said, similar to 1998 and 1999 when everything with a .com or .net after its name skyrocketed.
“After the collapse in the first tech bubble in 2001 and 2002, you saw selective winners. And I think after the collapse we have out of 2022 of this euphoric tech era, we’re seeing selective winners,” he said.
Of the seven or eight leading tech companies today, only a few of them are trading on very demanding multiples where investors would have to see extraordinary growth in earnings for the stocks to be priced reasonably, he said, and two of them are trading on very undemanding multiples.
“And Microsoft and Apple, they are profit juggernauts. They’re not on low multiples but I wouldn’t say they’re on unfairly high multiples either. I think in that group there’s a lot of discrimination you can use between price and quality. I would not expect a return to the mania we had, and I think you want to be really selective on the big seven or eight going forward.”
Some other strong themes, the portfolio managers said, include a leisure travel rebound while business travel is taking a longer recovery; corporations completing spinouts of non-core businesses; offline retail converting to online; on-premise to cloud computing; streaming media taking the lead over cable TV; and the beginning of a renaissance for nuclear energy.
“I think we’re going to see a slow moving, but huge, nuclear wave,” Casey said.