High inflation and interest rates brought significant pain to growth equites in 2022. Looking forward, attractive valuations and resilient earnings fundamentals are presenting an attractive opportunity to patient investors. Jen Blaha, director of Portfolio Construction and Analytics at Allspring, discusses this with Mike Smith, senior portfolio manager, and Ozo Jaculewicz, senior portfolio specialist, with the Discovery Growth Equity team.
Mike Smith: What I want to state very clearly today is last year’s pain is creating this year’s opportunity and it is the type of opportunity that doesn’t come around very often.
Jen Blaha: That was Mike Smith, senior portfolio manager with the Discovery Growth Equity team at Allspring. Joining him is Ozo Jaculewicz, senior portfolio specialist on the team. I’m Jen Blaha, director of Portfolio Construction and Analytics at Allspring, and you’re listening to On the Trading Desk®. Mike and Ozo are here to talk about their recent paper, titled Outlook for Equities: Growth Stocks Are Coiled Springs. You can find this paper on allspringglobal.com. So please feel free to check it out. And now, without further ado, Mike and Ozo, thanks so much for being here.
Mike: It’s great to be here, Jen.
Ozo Jaculewicz: Thank you, Jen. Great to be here.
Jen: Well, growth stocks are off to a fantastic start this year. And coming out of the misery of 2022, I’m sure growth managers like yourselves are doing a bit of a happy dance and embracing this much-needed respite. For many investors, though, the question on our minds is whether these growth stocks can sustain this comeback. To start us off, though, as part of Allspring’s 2023 investment market outlook, you brought up the analogy of growth stocks as coiled springs. Can you outline some of those high-level points of your argument there?
Mike: Sure, Jen. I think it’s important to remember what 2022 was actually like. There was literally nowhere to hide. Stocks and bonds went down. There was a lot of damage done across every asset class. That’s well documented and understood now, but I still think the amount of damage done in growth stocks is underappreciated. If a stock is down 40% but the business grew 40%, most people would assume the discount in price is just the change in the price, which I said was the 40% figure. But the reality is that the change in value is 60%, not 40%, because you have to account for that growth. In my experience in life, 60% off sales are pretty rare events that don’t last long. What I want to state very clearly today is last year’s pain is creating this year’s opportunity and it is the type of opportunity that doesn’t come around very often. Picture a spring and assume nothing about the spring is changing except the amount of tension it is under. Its weight is the same, its color is the same, and all of its physical characteristics are the same, except it has been squeezed down. That’s a pretty big deal, actually, because the potential of what happens next has changed a lot. This is exactly what happened to growth stocks last year. Virtually everything else stayed the same or similar. Growth was the same or similar. Margins were the same or similar. Competitive dynamics were relatively unchanged, but the multiples compressed a lot. And, therefore, the opportunity for investors to exploit what happens next has changed a lot as well.
Jen: I can definitely see the parallels with this analogy. These growth stocks have basically absorbed the shock that the markets brought on last year and it makes intuitive sense that when the spring releases, so to say, the strong base of resilient earnings will help propel these stocks forward in the form of those future attractive returns. But we may have to be patient here as there are a number of factors at play, which brings me to my next question. In light of recent recession fears and falling revisions to earnings estimates, can you elaborate on your viewpoint that growth stocks can be resilient or insulated from some of these extraneous factors?
Ozo: Yes, I’ll take that question, Jen. This is Ozo, and Allspring’s investment outlook for 2023 is titled Purposefully Divergent. And where our viewpoint falls into that divergence is essentially right now there’s such a fixation on the Fed (Federal Reserve) and Fed policy and the outlook for inflation. And after the interest rate shock that we experienced in 2022, as Mike mentioned, there was tremendous pressure on valuations, particularly of growth stocks. I think a lot of investors feel a bit stunned and even burned by the amount of volatility that they’ve seen in the high growth space. Well, that volatility has actually created some misperceptions and mispricings about growth stocks. Let me share a quick story. I was fortunate enough to go to Allspring’s client symposium in London recently. My first day when I left the hotel in London, it was overcast and a vendor was selling an umbrella for £5. The next day when I left my hotel, there was a heavy raining downpour and that exact same umbrella from the same vendor was now selling for £12. That’s a little bit how we view growth stocks. Growth stocks have some defensive traits that I think investors are missing right now. Many high-quality growth stocks have very durable underlying fundamentals. They have strong balance sheets; financial flexibility; and, most importantly, their clients and their end markets have secular demand traits, not cyclical. Growth stock portfolios are often not a pro-cyclical portfolio. So, as we graduate out of this period of fear and a focus on multiple compression and investors refocus on the durability of underlying earnings growth and free cash flow, we think growth stocks will be like that umbrella in a rainstorm and insulate our clients from all of the macro uncertainties.
Jen: So, it sounds like those fundamentals are really going to be what separates the weak from the strong, so to speak. But you mentioned the Fed there, so let’s turn the focus a little bit there. With interest rates increasing, some investors believe we’re now in a new regime—one marking the end of the free-money era that benefited many poor-quality businesses. What is your view toward this argument and the possible impact to performance from growth stocks?
Mike: To me, the question is not are we recovering—it’s what are we recovering to? For us, we’re recovering to a scenario that we’re very familiar with. Our team has been talking about three forces that start with the letter D now for the last six years. The first is debt. The United States is a $26 trillion economy with $32 trillion of debt. A 120% debt-to-GDP (gross domestic product) ratio is well past the point where growth is constrained by our indebtedness. And with the recent increase in interest rates, a very significant amount of that GDP is going to go just to pay the interest expense. At the same time, the second D that’s in play is demographics. Roughly 10,000 Baby Boomers retire every day in our country. About 75 million will retire between now and 2030. There’s just not enough labor to replace that exodus. And if the workforce is shrinking and an increasing amount of GDP is going to service our debt, we can safely predict we’re recovering to a low growth environment. And that’s important because that’s actually the best environment for growth stocks and growth stock investing. It creates the opportunity for a scarcity premium to return. We think roughly two-thirds of publicly traded companies will fail to grow at a rate of 9% or greater over the next two to three years, which means only one-third will. If you raise the bar into the teens or 20%, like many of our companies are growing, you’re starting to talk about something that’s very hard to find, and things that are hard to find are worth a lot. So, we’re very excited about that opportunity. And then I think for active investors, the third D is important. The pace of disruption is only continuing. There are 8 billion people on the planet, but there are 10 billion devices connected to the internet. And if you think about all of the data that’s produced and analyzed to create opportunities and advantages for the companies on the right side of change and then all of the value that’s destroyed for the companies on the wrong side of change, that is a fertile environment to pick winners and losers, which is exactly what active managers do.
Jen: Now can you give the audience a little more color on the characteristics of the companies that tend to hold up better than others? What is your team looking for in terms of some attributes that you want to see in a company?
Ozo: Jen, I’ll take that one. For us, it’s a key question around time horizons. In the short term, investors tend to focus on those macro events and those changes in rotations and valuation multiples. When you extend time horizons, it’s earnings growth, free cash flow, and returns on capital that ultimately drive compounding. And when you identify these big secular winners—stocks that can compound at very high rates over many, many years—that is a life-changing investment opportunity for people seeking wealth. And that’s what growth investors do. We are hunting for companies that are on to the next big innovation. Our portfolio is full of companies that are going after huge problems, whether it’s sustainable energy, then transition to cloud software, major health care treatments, a shortage of software talent, and I could go on and on. These are huge addressable markets. And as Mike pointed out, despite all the macro crosscurrents, those innovations haven’t changed. So, the key characteristics of companies that can power through what may be a difficult macro environment are those companies with superior revenue growth, profitability, and returns on capital, and those are found in the growth universe. And right now, this opportunity to acquire those tremendous companies after a period of significant drawdowns is fairly rare and is a very favorable setup. So, our call to action to our clients is to stay committed to diversification and to extend your time horizon. Look into 2024 and beyond for the companies that can put up superior growth and have durable fundamentals. Those companies right now are coiled springs.
Jen Blaha: And I think coming out of a year like 2022, it’s refreshing for all of us to think of this year and the next as a period of opportunity more than anything. So, Mike and Ozo, I’d like to offer a sincere thanks in joining me today.
Mike: Thanks, Jen.
Ozo Jaculewicz: It was our pleasure, Jen. Thank you.
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