Frank Caruso, CFA; John H. Fogarty, CFA; & Vinay Thapar, CFA
Growth stocks are under intense pressure as rising interest rates change the dynamics that drive stock valuations. But market volatility shouldn’t distract investors.We believe in business Products that enable sustainable growth in a down economy will ultimately be valued for their commercial benefits and return on investment potential.
Market corrections are always painful, but investors in growth stocks have been hit particularly hard this year. The Russell 1000 Growth Index fell 21.4% through May 27, underperforming the S&P 500, which fell 12.2%. The recent performance has been driven by a risk-off mentality that has led to massive outflows from growth stock funds. Rising interest rates also tend to disproportionately hurt high-growth stocks, especially more expensive ones, because it puts upward pressure on the way investors discount long-term cash flows. However, as the cycle winds down, we believe economic weakness will inevitably put more downward pressure on cyclical profits than growth company profits.
Uncertainty on multiple fronts clouded the outlook. The Federal Reserve’s tightening of monetary policy to combat rampant inflation could slow economic growth and strengthen the dollar, putting pressure on multinational corporations’ international profits. Meanwhile, the war in Ukraine and China’s lockdown measures to combat the COVID-19 outbreak could hurt global economic growth. Inflation, rising interest rates and supply chain disruptions all jeopardize the prospect of an eventual recovery.
Profitability should prevail
Market and business conditions have changed dramatically. However, we believe some enduring principles will serve investors well during the current volatility. Profitability is the key to a strategic approach to growth investing.
To be sure, earnings will be harder to come by as prices rise and GDP growth slows. Yet even with the economy slowing, the U.S. remains the world’s most attractive market for companies looking for profitable growth.US stock market is about Two-thirds of global large-cap companies report earnings growth feature.
For better or worse, we believe profitability is a clearer indicator of a company’s future prospects than earnings. Companies can easily manipulate earnings to avoid showing the full picture of the health of the business. In our view, metrics such as return on invested capital (ROIC) and return on assets (ROA) are a better measure of a company’s economic performance and ability to deliver results over time.
Companies with high ROA and ROIC underperformed in the recent correction. But short-term underperformance doesn’t mean that earnings metrics are compromised as a measure of long-term return potential. As the macroeconomic situation gets tougher, we believe profitability will come back into fashion. ROA and ROIC help chart the way for companies with sustainable growth drivers that can withstand external pressure. Likewise, a high-quality balance sheet will provide advantages, as rising interest rates increase financing costs, especially for companies with higher debt burdens.
Targeting a portfolio to the right companies for these situations requires a differentiated approach. While rising costs, supply chain disruptions and labor challenges have been common themes of the most recent earnings season, each company’s business and financial dynamics are different.
For example, we observe very different pricing power and margin impacts for two industrial companies. Lincoln Electric Holdings raised prices by 19% year over year, but its gross margin — the percentage of revenue that exceeds cost of sales — improved by only 200 basis points due to higher costs. Stanley Black & Decker prices up 5% YoY, but gross margins contract 800 basis points. Moral of the story: Investors should be careful not to make sweeping generalizations about a company’s or industry’s ability to meet these challenges.
Reinvestment drives sustainable growth
Companies that can stay profitable in tougher markets will have another advantage: having excess cash to reinvest. From our point of view, Strategic, self-funded reinvestment is an important component of future growth underpinning long-term return potential. We believe it creates better shareholder value than corporate buybacks or dividends.
When profitability is under pressure, keep an eye out for companies that are cutting back on reinvestment. Underinvestment is likely to support margins and make quarterly earnings reports even duller. But it can also mask vulnerabilities and a lack of preparation for potential threats to the model. During the pandemic, we aim to verify that fast-growing companies are investing enough to maintain and improve profitability as consumer and business behavior normalizes across industries. In times of stress, this may sound counterintuitive. on the contrary. While things may be different today, this key investment question remains as relevant as it was then.
This year’s market correction reflects genuine concerns about the future. The sharp drop in growth stocks rattled investors. Macroeconomic headwinds make it difficult for investors and corporate management teams to forecast with confidence.
However when Guidance is vague, active investors with independent research capabilities can make a difference. Today’s lower valuation sets the stage for a healthier recovery and reinvestment in stocks that have been unfairly punished during the downturn. Companies that can consistently deliver profitable results can underpin a growth stock portfolio that can withstand periods of slowing economic growth and shine when a recovery materializes.
The views expressed in this article do not constitute research, investment advice or trading advice, and do not necessarily represent the views of all AB Portfolio Management teams. Views change over time.
Editor’s Note: The summary bullet for this article was chosen by Seeking Alpha editors.