The Underperformance of Quality Growth Stocks
This year, the market has been laser-focused on the direction of rates and inflation. Many investors have fled to what they might perceive as “safer” investments, which seem to be stocks that are cheap in terms of valuations, exposed to commodities, or those that may have underperformed during the pandemic. Amid this significant repricing of “risk” assets, companies that have more of their value tied to future growth, and thus future free cash flows, have been out of favor.
Why Hasn’t Quality Protected on the Downside?
We define quality based on balance sheet strength, earnings growth and cash flows, organic growth, and low leverage or debt. The simple market reaction to higher inflation and higher rates has been to buy value and sell growth, regardless of business characteristics. We can see this dynamic by looking at style factors and sectors that have been in favor, as measured by stock price performance of high growth/high price-to-earnings (P/E) multiple versus low growth/low P/E multiple. Figures 1 and 2 use the Russell 1000 Growth and 2000 Growth Indices to depict this across U.S. large- and small-cap universes.
Figure 1: Sector and Style Dynamics: U.S. Large-Cap Growth Universe
Source: Bloomberg. Data as of 9/30/2022. The U.S. Large-Cap Growth Universe is defined by the Russell 1000 Growth Index. Factor Returns: Defined, modeled, and calculated by Bloomberg, help decompose returns into a combination of style, industry, geography, and currency exposures. Style factor exposures are estimated for the index based on underlying fundamental and security characteristics as defined by Bloomberg’s Equity Factor models. Relative factor returns calculated by Bloomberg as the top quintile returns minus the bottom quintile returns. See the important disclosures section for definitions for the Bloomberg style factors. Sectors are defined by GICS classification.
Figure 2: Sector and Style Dynamics: U.S. Small-Cap Growth Universe
Source: Bloomberg. Data as of 9/30/2022. The Small-Cap Growth Universe is defined by the Russell 2000 Growth Index. Factor Returns: Defined, modeled, and calculated by Bloomberg, help decompose returns into a combination of style, industry, geography, and currency exposures. Style factor exposures are estimated for the index based on underlying fundamental and security characteristics as defined by Bloomberg’s Equity Factor models. Relative factor returns calculated by Bloomberg as the top quintile returns minus the bottom quintile returns. See the important disclosures section for definitions for the Bloomberg style factors. Sectors are defined by GICS classification.
It has generally felt more like an allocators’ market over the past year where, for many investors, macro issues have overshadowed the fundamental performance of specific companies. The market is favoring value factors, dividend yield, and companies with high amounts of debt. It’s almost the exact inverse of what we have seen historically drive markets over the long term.
That said, we believe there are a handful of drivers of long-term returns, specifically earnings growth and dividend yield. In our view, the dividend yields of the businesses in favor now will face competition from bond yields. In contrast, the companies we seek have double-digit organic earnings growth that, based on our experience, could drive long-term returns to surpass the P/E multiple compression we’re seeing in this market environment.
History has shown us that earnings growth does matter. Figure 3 shows the performance of specific quality characteristics of return on equity, net debt/EBITDA, and cash flow variability. These characteristics can be indicators of profitability, leverage (or debt levels), and consistency of cash flows, all areas of focus for us when it comes to researching companies. The difference in the performance of these characteristics is notable, with profitability being in favor and high debt levels and inconsistent cash flows being out of favor during the recessionary period of 2007-2009. When growth becomes increasingly scarce, quality factors tend to shine through tougher times.
Figure 3: Quality Factors During from 12/1/2007 to 6/30/2009
Source: Bloomberg. Data from 12/1/2007 to 6/30/2009. The Large-Cap Growth Universe is defined by the Russell 1000 Growth Index. The Small-Cap Growth Universe is defined by the Russell 2000 Growth Index. Factor Returns: Defined, modeled, and calculated by Bloomberg, help decompose returns into a combination of style, industry, geography, and currency exposures. Style factor exposures are estimated for the index based on underlying fundamental and security characteristics as defined by Bloomberg’s Equity Factor models. Relative factor returns calculated by Bloomberg as the top quintile returns minus the bottom quintile returns. See the important disclosures section for definitions for the Bloomberg style factors. Sectors are defined by GICS classification. The performance shown does not necessarily reflect returns achieved under current market conditions. Potential investors should note that the periods shown were marked by a lack of liquidity, failing prices for public equity, and unusually high market volatility. Returns may be materially different in other types of market environments. Investors should consider such factors to determine whether past returns are an appropriate comparison to current markets.
What Do We See in Our Research? What Keeps Us Optimistic?
In a volatile stock price environment like today, we continue to see resilience in the companies we own and attractive opportunities. While the current market stress may cloud some investors’ vision of the long term, our teams are focused on the bigger picture. Now, some of the highest-quality growth businesses we know are trading at compelling valuations. And, we think the longer-term outlook is promising for high-quality companies, especially as growth seems harder to come by.
Important Disclosures
This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of September 2022 and may involve a number of assumptions and estimates which are not guaranteed, and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness, or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction. Past performance does not guarantee future results and profitable results cannot be guaranteed.
This information is not intended to be construed to equate to the expected or projected future performance/returns of a portfolio managed by Polen Capital.
The Russell 1000® Growth Index is a market capitalization weighted index that measures the performance of the large-cap growth segment of the U.S. equity universe. It includes Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The index is maintained by the FTSE Russell, a subsidiary of the London Stock Exchange Group.
The Russell 2000® Growth Index is a market capitalization weighted index that measures the performance of the small-cap growth segment of the U.S. equity universe. It includes Russell 2000® Index companies with higher price/book ratios and higher forecasted growth values. The index is maintained by the FTSE Russell, a subsidiary of the London Stock Exchange Group.
The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index.
Bloomberg Factor DefinitionsValue is calculated as a weighting of each stock’s Book Value to Price, Cash Flow from Operations / Market Cap, Net Income – Last 12 Months (LTM)/ Market Cap, EBITDA LTM / EV, Earnings/Price (BF1Y) and Sales LTM/EV
Size is calculated as a weighting of each stock’s natural log of total assets, sales and market cap
Dividends is the indicated dividend yield of a stock
Profitability is calculated as a weighting of each stock’s EBITDA Margin %, Return on Assets, ROCE and ROE over the last 12 months
Leverage is calculated as a weighting of each stock’s Net Debt/(Book Value + Net Debt), Net Debt/Total Assets and Net Debt/(Market Cap + Net Debt)
Growth is calculated as a weighting of each stock’s estimated next year’s EPS growth, 5-year annualized net income growth, estimated next year’s sales growth, 5-year annualized sales growth, and 5-year annualized asset growth
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the entire market or a benchmark. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.
Momentum is a measure of overall market sentiment, calculated as the change in the value of a market index multiplied by the aggregate trading volume occurring with the index components
5 Year Average Return on Equity is calculated as the 5-year average normalized return on common equity.
5 Year Cash Flow Variability –calculated as the standard deviation of growth in trailing 12-month cash flow from operations looking back over the past 5 years.
ROE Growth is calculated as the last 12 months normalized return on common equity minus 5-year average. Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity.
Net Debt shows how much cash would remain if all debts were paid off and if a company has enough liquidity to meet its debt obligations. Net debt is calculated by subtracting a company’s total cash and cash equivalents from its total short-term and long-term debt.
EBITDA Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a metric that measures a company’s overall financial performance
Net Debt/EBITDA Ratio is net debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio measures financial leverage and a company’s ability to pay off its debt. Essentially, the net debt to EBITDA ratio (debt/EBITDA) gives an indication as to how long a company would need to operate at its current level to pay off all its debt. Return on Capital Employed (ROCE) – a profitability ratio, measures how efficiently a company is using its capital to generate profits.
Enterprise Value (EV) is the total value of a company, defined in terms of its financing. It includes both the current share price (market capitalization) and the cost to pay off debt (net debt, or debt minus cash).
Book Value is a company’s equity value as reported in its financial statements
Price-to-Earnings Ratio (P/E) relates a company’s share price to its earnings per share
Dividend Yield is a financial ratio that tells you the percentage of a company’s share price that it pays out in dividends each year
Return on Equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity
Free Cash Flow is the cash leftover after a business pays its day-to-day operating expenses
