Will growth stocks still outperform? – ShareCafe

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Global growth stocks have had a golden period in recent years. This has continued throughout the pandemic, as lifestyles (and consumption habits) quickly adapted to new lifestyles.

Low interest rates and business innovation have led to renewed investor interest in stocks of well-managed global companies with prospects for long-term earnings growth.

Yet the start of 2022 has seen a reversal in the relative fortunes of growth and value stocks. Rising interest rates increased variable corporate borrowing costs, which impacted earnings. Higher long-term interest rates also increase the discount rate of corporate equity, which reduces the present value of future earnings and dividends – and therefore the market value.

This has impacted the valuations of growth stocks – which depend on the growth of earnings that will be made in the future – more than value stocks. The latter companies — such as mining, energy, banking, and consumer staples — tend to generate more immediate and predictable profits.

Will growth stocks rebound?

There are good reasons why many high-quality growth stocks should perform relatively strongly during the next phase of the economic cycle.

The blind selling of growing companies this year has extended beyond those with little or no cash flow and questionable business models. Overall, quality growth stocks underperformed value stocks, leaving some large valued companies at more attractive valuation levels. This implies higher potential returns in the medium and long term.

Additionally, growth stocks are positioned to benefit from longer-term secular trends that remain intact in the post-COVID world:

  • Working from home is here to stay. This provides growth opportunities for a wide range of disruptive businesses, as people continue to work and shop at home, while consuming media, entertainment and dining “from the couch”.
  • The decarbonization of the global economy is now irrevocably underway, accelerated by the US Inflation Reduction Act. The war in Ukraine could lead to higher fossil fuel prices and increased coal production, but only in the short term. Decarbonization benefits companies in various sectors (e.g. electric vehicles, green project financing and renewable energy technologies) that are not sensitive to the economic cycle.
  • The tendency of affluent professionals to delay starting a family is expected to continue through the recession. This will support the secular growth in demand for luxury goods and other discretionary consumer spending, much of which is supported by the recovery in leisure travel.

Value investing may not get you far

  • The good news is now likely fully priced into the current stock price. Continued outperformance in value stocks would require sustained outperformance in large sectors such as energy and financials.
  • Energy has certainly benefited from strong cash flow lately. However, share prices now reflect this, existing supply is already being expanded and new supply will be added in the medium term. Eventually, either prices will fall or windfall taxes are likely to be imposed – as seen recently in Queensland and the UK.
  • The banking sector should be affected by higher interest rates. The banking sector is expected to face a slowdown in the housing market with less new mortgage business. Over time, the impact of increased bad debts will further offset the benefit to banks of wider credit lines, which is provided by higher interest rates.
  • Not all corporate profits are cyclical. A likely decline in household and business spending will have a direct impact on corporate earnings, but not all growth stocks are cyclical. Growing companies in healthcare, pharmaceuticals, property management and agricultural technology are largely protected against such a drop in spending.

Capturing returns on investment in the next phase of the market

Do not assume continued outperformance of value stocks. Growth stocks are now better valued, will continue to benefit from long-term trends, do not count on rising spending, and do not face the challenges of current “hot” value sectors.

Quality growth stocks offer opportunities to capture sustainable long-term earnings growth. So while the economic cycle should be carefully considered, simply waiting for the downturn to pass can impact returns.

Investors with a long-term horizon and a willingness to shrug off short-term market volatility should benefit from exposure to high-quality, innovative global companies that can grow their earnings over time.

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