1 JUL, 2022
By Alistair Wittet
December 2021 the optimism about growth investing seemed limitless. 6 months later the investing world looks very different. Investors have made a big move into value stocks driven by a spike in inflation and interest rates turbocharged by Russia’s war in Ukraine. We believe the pendulum might well swing again. Here we explain why.
Let us start at the beginning. The bust of the ARK Innovation ETF over the past few months can be taken as an extreme example for the wave out of growth stocks. Seasoned investors remember the technology bubble at the turn of the century. NASDAQ lost 71% in 3 years at the beginning of the century. ARK lost 70% in 8 months. This has been a fast speed correction of growth stocks.
The ARK Innovation ETF is heavily invested in loss making technology companies. We invest in companies with strong balance sheets, high profitability, low sensitivity to the economic cycle, dynamic long-term growth potential and pricing power. We are growth investors, but of a very different kind compared to the ARK Innovation ETF.
All our companies and portfolios have a PE valuation which the ARK Innovation ETF does not have. Our companies are highly profitable, ARK’s companies make losses. And that is exactly where the differences matter a lot in our view.
According to Warren Buffett, ‘price is what you pay, value is what you get’. With quality growth you pay a PER, a price, and you get sustainable and profitable growth, you get value.
With growth stocks falling out of grace, the correction of our quality growth funds y-t-d was severe. For example, the portfolio holdings of our European flagship fund, Comgest Growth Europe, trade today at 21x PE compared to 32x PE at the end of last year. Today’s valuation is line with the 3 decades of track record for the fund while 32x PE was a peak valuation.
Much like in a storm the hot (valuation) air has been cleared and is now pure again. While the price for quality growth stocks looks right again in our view, how about the value you can expect from quality growth stocks when you invest today?
The European economy probably dipped already into stagflation, a poisonous combination of high inflation and economic stagnation. What equity investors need now are companies which can deal with inflation and have little sensitivity to the weakening macroeconomic backdrop. Quality growth stocks have the right credentials to preserve earnings growth, free cash flows and hence their value in tough economic environment.
Our European growth fund promises 26% EPS growth this year and 17% in 2023 unchanged from 6 months ago. 48% compounded earnings growth over 2 years is tangible value for investors in times of high inflation and rising interest rates.
That leads us straight to a bear argument against growth stocks. Theory suggest that value stocks are less interest rate sensitive than growth stocks as investors use a DCF to ascribe fair values to stocks. In theory rising interest rates reduce the net present value of longer duration growth stocks more than for shorter duration value stocks. So how can we claim that it is the right moment to reconsider quality growth?
Investors should not ignore how free cash flows evolve in a period of high inflation and rising interest rates. Price increases create valuable economic rents for shareholders which are too often overlooked in the debate about interest rate sensitivity of stocks. Yet pricing power is crucial in practice.
ASML is a company with strong pricing power. It is the global monopolist in latest generation lithography equipment. Its machinery is vital to keep up Moore’s Law which claims the size of a semiconductor shrinks by half every 2nd year. This miniaturization is the bedrock of technological progress. And technological progress has its price with ASML’s latest generation EUV equipment selling at more than 150m USD per machine. ASML’s PE valuation came down from 48x to 25x in 6 months. Its value is largely immune to inflation thanks to its strong pricing power.
Another company of that kind is Novo Nordisk the leader in the global diabetes market. Its newest drug Wegovy is the only drug approved by the FDA in the nascent obesity drug market, a USD40bn market opportunity. It can be a life-saving drug especially in Covid times. Hence selling such drugs is not a question of price.
Novo Nordisk and ASML are 15% of the Comgest Growth Europe fund. They protect shareholders from high inflation and we believe are much less sensitive to interest rate rises in practice than the theoretical debate about equity duration might suggest. We therefore disagree with the view that growth stocks should be unilaterally avoided in times of rising interest rates. In our view it is much better to own a long duration growth stock with pricing power compared to a short duration value stock without pricing power in current times.
Another common feature of value stocks is their high sensitivity to the economic cycle. Close to half of the MSCI Europe Value index, for example, is comprised of financials, energy and commodity stocks. Heading into a stagflation might not be the best moment to consider such kind of stocks. Our European flagship fund does not have exposure to these sectors and never had over the past 3 decades. As a quality growth investor we always sought to avoid their cyclicality.
The biggest European value sector, financials, is already showing signs of fatigue. European financials rank worst in terms of earnings revisions and growth for the year 2022. 2022 earnings estimates were revised down by 9% over the past 3 months leaving the sector with an expected decline of earnings for the year of 14%. Rising interest rates are a welcome support to many banks, yet the credit quality might deteriorate on the back of the weakening economic outlook.
For the time being energy and materials stocks are the only bright spots left of the value segment in Europe. As regrettable as it might be, the war in Ukraine has created a benign pricing environment ranging from oil & gas to fertilizers and soft commodities. Stock market investors say ‘political markets have short legs’. It remains to be seen how sustainable this commodity rally will be.
In summary we are confident that long-term investors get good value at the right price when investing in quality growth stocks today. The valuation correction has been short and sharp for those companies which know how to deal with inflation and keep going even in a low growth environment.