Growth stocks are under acute pressure as rising interest rates change the dynamics that drive equity valuations. But market volatility shouldn’t distract investors. We believe companies that can deliver sustainable growth in a sluggish economy will ultimately be prized for their business benefits and investment return potential.
Market corrections are always painful, but investors in growth equities have suffered a particularly harsh blow this year. The Russell 1000 Growth Index tumbled by 21.4% through May 27, underperforming the S&P 500, which fell by 12.2%. Recent performance has been driven by a risk-off mentality that has fueled significant outflows from growth stock funds. Rising interest rates also tend to disproportionately hurt higher-growth stocks, especially more expensive names, because it puts upward pressure on how investors discount long-term cash flows. However, as this cycle plays out, we believe a weakening economy will inevitably put more downward pressure on cyclical profits than on profits of growth-oriented companies.
Uncertainty on multiple fronts is clouding the outlook. The US Federal Reserve’s efforts to combat rampant inflation by tightening monetary policy is likely to slow economic growth and strengthen the US dollar, pressuring international profits of multinational businesses. Meanwhile, the war in Ukraine and China’s lockdown measures to fight a COVID-19 outbreak threaten to impair global economic growth. Inflation, rising rates and supply chain disruptions all jeopardize the prospects of an eventual recovery.
Profitability Should Prevail
Market and business conditions have changed dramatically. Yet we believe that some abiding principles will serve investors well through the current volatility. Putting profitability at the center is the linchpin of a strategic approach to growth investing.
To be sure, profitability will be harder to come by as prices rise and GDP growth slows. Yet even in a decelerating economy, the US is still the world’s most attractive market for finding profitable growth companies. US equity markets are home to about two-thirds of the world’s large-cap companies with profitable growth characteristics.
In good times and bad, we believe profitability offers a clearer picture of a company’s future prospects than earnings. Companies can easily manipulate earnings to avoid showing a complete picture of business health. Measures such as return on invested capital (ROIC) and return on assets (ROA) can provide a better gauge of a company’s economic performance—and its ability to deliver results over time, in our view.
In the recent correction, companies with high ROA and ROIC have underperformed. But short-term underperformance doesn’t mean profitability metrics are impaired as measures of long-term return potential. As macroeconomic conditions get tougher, we believe profitability will come back into vogue. ROA and ROIC help point the way to companies with sustainable growth drivers that can endure external pressures. Similarly, high-quality balance sheets will offer advantages as rising interest rates boost financing costs, particularly to companies with larger debt burdens.
Positioning portfolios with the right companies for these conditions requires a discriminating approach. While rising costs, supply chain disruption and labor challenges were a common theme in the recent earnings season, every company’s business and financial dynamics are different.
For example, we observed two industrial companies with starkly different pricing power and margin impacts. Lincoln Electric Holdings raised prices by 19% year over year, but its gross margins—the percentage of revenue that exceeds the cost of goods sold—only improved by 200 basis points because of rising costs. Stanley Black & Decker raised prices by 5% year over year, but its gross margins contracted by 800 basis points. The moral of the story: investors should beware of making sweeping generalizations about the ability of companies or industries to cope with these challenges.
Reinvestment Drives Sustainable Growth
Companies that can maintain profitability in a tougher market will have another advantage: having excess cash for reinvestment. In our view, strategic, self-funded reinvestment is an essential ingredient for future growth that underpins long-term return potential. And we think it creates better shareholder value than corporate buybacks or dividends.
When profitability comes under pressure, watch for companies that are cutting reinvestment. Underinvestment might prop up margins and flatter a quarterly earnings report. But it could also mask vulnerabilities and unpreparedness for potential threats to their models. During the pandemic, we aimed to verify that fast-growing companies were investing enough to maintain and grow profitability when consumer and business behavior normalizes across industries. In times of stress, that may sound counterintuitive. On the contrary. While conditions may be different today, this key investing question remains just as relevant as it was then.
Quality Points the Way
This year’s market correction reflects real concerns about the future. Sharp declines of growth stocks are unsettling for investors. And macroeconomic crosscurrents are making it very difficult for investors and company management teams to forecast with conviction.
Yet when guidance is murky, active investors with independent research capabilities can make a difference. And today’s lower valuations set the stage for a healthier recovery, as well as for reinvestment in stocks that have been unfairly punished in the downturn. Companies that can deliver profitable results with consistency can underpin a growth equities portfolio that is positioned to withstand a period of slower economic growth and to shine when a recovery materializes.