Quality growth — a less volatile sweet spot?

Investing in growth equities can offer investors opportunities to benefit from some of the most profitable and innovative companies in the world, but does the risk justify the potential reward? 

Investors expect big things from growth equities, which means these stocks can be susceptible to price volatility in the event that results disappoint, especially towards the more aggressive end of the spectrum. A characteristic of growth stocks is that most of their earnings are continuously reinvested in the hope of unlocking even greater returns, which means that when companies fail to meet expectations, price volatility surges.  A case in point: July’s sell-off of tech and AI stocks saw Tesla’s share price fall by more than 10% at the end of the month, in response to an earnings report that the market perceived as disappointing. These market moves are painful for investors, especially because the composition of the equity market has shifted in response to US megacap stock dominance.

When growth companies meet or exceed expectations, investors benefit. But as the US Federal Reserve cuts interest rates for the first time in four years, recession fears persist and the profitability of the largest US megacaps continues to come under scrutiny, many investors are wondering if growth equities still deserve a designated allocation in portfolios. 

The hidden price of growth at any cost

These concerns have prompted some investors to reassess their investment style and move away from growth in favour of core equity exposures, which sit halfway between growth and value on the style spectrum. But is there another way to participate in the opportunities within growth stocks? We think targeting high-quality growth companies that aren’t too expensive, sitting in the style space between core and aggressive growth, may offer a sweet spot: an alternative way to target long-term outperformance while reducing the potential for downside risk (Figure 1). 

Figure 1

Five ways to target quality growth

Long-term growth is about more than growth

If targeting high growth is about seeking out the companies that have the highest scope for earnings and revenue expansion, we believe seeking out companies that offer a compelling combination of growth and other characteristics can lead to a portfolio that sits between core and aggressive growth on the spectrum, which may result in a superior risk/reward over time. While we believe revenue growth is a good predictor of long-term excess return, based on our research, we think that cash-flow margin and return on capital (quality), cash-flow yield (upside potential) and the combination of share buybacks and dividend yield (capital return to shareholders) can also be powerful predictors of outperformance. We therefore focus on these in our process (Figure 2). We find that stocks with these characteristics are less dependent on one investment style, such as growth, in order to do well, meaning that they have the potential to perform well in a variety of different environments, not just ones in which high-growth stocks flourish. Conversely, this can also help protect relative performance when equity markets decline.  

Seek a more balanced approach to risk and reward

An investor in high-growth equities doesn’t necessarily expect that all the companies will achieve high returns. More commonly, some companies may do extremely well while other companies may do very poorly. The hope is that the most successful companies do so well that this counteracts the poorer performers. With this approach, the potential for reward may be great, but the potential for risk is also significant. Maths tells us that underperforming by 25% in down markets requires outperforming by 33% in up markets just to get back to neutral.

By contrast, we believe that targeting companies that offer growth as well as quality, capital returns and upside potential is likely to result in smoother performance by not having a narrow focus on growth at any cost. While there may be relative winners and losers in the short, medium and long term, the expectation is that this discipline around stock selection provides an element of downside protection that may be missing in more aggressive growth allocations.  

Pay attention to market signals

Equity markets are influenced by changes in the economic cycle. We believe that dynamic positioning informed by data supports an active investor’s ability to protect capital when the global economic cycle decelerates and to keep up when the global economic cycle accelerates. For example, we rely on a proprietary global cycle index to track when global economic activity is getting better or conversely getting worse. This dual focus on both top-down macroeconomic factors and bottom-up analysis enables us to tilt exposures based on where we are in the economic cycle. 

Consider the stock life cycle

Companies display different characteristics depending on where they are within their life cycle. Regardless of how a company might score on each of our four key attributes, a change in fundamentals can serve as an impetus to reassess its potential in the short and long term. This information can help inform elimination or buyback decisions.

Think beyond the Magnificent 7

The Magnificent 7 have been prominent drivers of equity market returns, but a narrow focus can lead investors to overlook sources of growth elsewhere. We believe a disciplined process can help identify ideas both within and outside of this group, and that it is possible to find alpha outside of the “Mag 7”, in sectors as diverse as industrials, communication services and financials. 

Figure 2

Key characteristics that can help support alpha generation over time

Case in point: investment example¹

Where can investors find quality growth stocks? We believe these companies exist in a range of sectors, such as:

• Technology leaders at the vanguard of enabling the digital revolution through AI
• Media companies increasing monetisation
• Consumer-orientated businesses with unique products or value propositions
• Health care companies benefiting from scale and innovation; and 
• Financial services leaders improving payments systems or supporting investment in the public and private companies of tomorrow

One example is a digital music streaming service that provides access to millions of songs and podcasts globally. This company is in the unique position of being the dominant music streaming provider with multiple avenues for future revenue growth. We see strong subscriber economics and advertising revenue potential as well as growth from a growing podcast platform driving margin expansion and free-cash-flow generation. At the same time, the company is returning cash flow to shareholders and trades at an attractive free-cash-flow multiple relative to the global opportunity set. 

Growth investing — is there another way? 

We believe that effective active management of growth equities should consider both the potential upside and downside. In general, investors have a tendency to underweight the probability that equity markets will decline. We believe downside protection can be accomplished in a few ways: a focus on high-quality companies, maintaining a valuation discipline, avoiding companies with the most negative earnings estimate revisions and an approach to portfolio construction that manages active exposures to stocks, sectors and factors with the ability to position for downturns in the economic cycle. 

Today’s unique market backdrop leaves the door open to structurally higher inflation and interest rates over the next decade. In such an environment, central banks will have to consistently choose between prioritising growth or inflation. This dynamic could lead to shorter cycles, more macro volatility and less market liquidity, offering a potential edge for active managers focused on quality growth companies that can consistently deliver free-cash-flow and earnings growth, as margin expansion and valuation become more important.

¹ Commentary provided is for illustrative purposes only and should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer or solicitation to buy or sell securities.