Let's talk about growth_Carl Van Nieuwerburgh

ARTICLE

LET’S TALK ABOUT GROWTH

By Carl Van Nieuwerburgh,
Quantitative Equity Strategist

After a dismal 2022, growth stocks have seen a strong rebound this year – while their notorious negative correlation with bond yields can explain their 2022 relative return, at first sight it does not provide an explanation for this year’s surge in growth stocks’ performance. Still, while yields have not contracted, a normalising inflation and sluggish growth outlook have implied the end of tightening monetary policies and less abundant growth, two factors that are typically favourable for the market segment.

In this research article, we investigate the fundamentals of growth stocks. They have been attributed with quality and defensive characteristics, and we examine the extent to which this is the case. We also shed light on two terms related to growth stocks, namely ‘mega cap growth’ and ‘non-profitable growth’. We first start, though, by charting growth expectations for growth stocks through time, focusing on the stocks with the 10% highest revenue growth expectations, irrespective of sectors.

SETTING THE SCENE: GROWTH EXPECTATIONS, PERFORMANCE, AND VALUATION

A few things stand out from the first chart below:

- The millennium started with high expectations for growth stocks, which faded over a couple of years – commonly referred to as the deflation of the Technology growth bubble.

- Growth expectations for US growth stocks are typically 5% (or more) higher than expectations for EU growth stocks. This is at least partially explained by sector weight differences. The gap increased around the Euro-crisis.

- The Corona-crisis meant the strongest positive growth shock for these stocks in over 20 years. Companies that significantly profited were those that facilitated the stay-at-home/work-from-home trend and pharmaceuticals. Soon afterwards, the surging inflation also helped to boost sales figures.

- Current growth expectations still compare favourably with the pre-corona period, even if the corona-induced growth shock faded.

Other analyses – not shown here – show that median growth expectations for low growth stocks are more stable and usually slightly positive. This means that growth dispersions are typically a few percentage points above the expected growth for growth stocks.

The second chart below visualises the year-over-year return spread between high and low growth stocks. We can see that:

- The magnitude of relative returns witnessed since the Corona crisis immediately stands out. Especially in the US, the return differences reached extreme levels, but also in Europe, they never reached similar levels in the last few decades. While relative returns were more extreme in the US, the positive growth shock during the COVID crisis was nonetheless equally large in Europe as in the US.US yields that declined more substantially than their EU equivalents at the start of the Corona-crisis could have contributed to US relative returns reaching more extreme levels.

- The reversal started in 2021, anticipating a post-COVID rebound, a reversal that was lengthened by the unexpected surge in inflation and rates that followed. As from the end of 2022, a normalising growth and inflation environment has led to a reversal in the other direction.

Source: DPAM, Factset, MSCI – June, 2023

With such a strong outperformance, especially of US growth stocks, it is no surprise that the valuation premium for growth stocks skyrocketed, as is evident from chart 3. The subsequent reversal of relative performance pushed the premium for growth stocks lower, until it reached pre-Covid levels at the end of 2022. The current high valuation premium for growth stocks is consistent with the current high growth dispersion. Further investigation reveals, though, that the relationship between the P/E premium and growth dispersion is very high today, especially in the US.

Source: DPAM, Factset, MSCI – June, 2023

To evaluate the heterogeneity and dynamics of high growth stocks, we now plot sector weights for high growth stocks below (not all sectors are shown). The different composition in the US and EU immediately stands out.

In the US, high growth stocks were dominated by the technology sector around the turn of the millennium. In the following years, the technology sector’s weight declined from nearly 80% to around 20% in 2009. This marked the sector weight’s low, and in the decade that followed, its weight increased again to nearly 60%.

In the US, the energy sector’s weight also stands out, influenced by oil price volatility and the US shale boom.

In Europe, IT & Communication Services also made up nearly 60% of high growth stocks in 2000, only to see their weight practically vanish in 2009. The renaissance that followed was not as impressive as in the US. Today, they represent around 20% of EU high growth stocks. As a result, growth stocks are more diversified in Europe than in the US, but we have seen that it comes with lower aggregate growth expectations.

Finally, we see that both in the US and in Europe, the consumer discretionary sector has been an important beneficiary of the corona crisis. Today, their weight is again near their pre-corona level.

Source: DPAM, Factset, MSCI – June, 2023

GROWTH’S QUALITY

We now turn our attention to the link between quality and growth. For some time now, investors have associated these two attractive characteristics with each other. The remark was made that Growth’s outperformance was different this time, as growth companies were more profitable than they were at the turn of the millennium.

From the different quality dimensions that exist, we explore profitability and volatility, starting with profitability.

The two charts below show the net profit margin evolution of high and low growth stocks in the US and EU, excluding financials. A couple of observations can be made:

- Most of the time, margins for high growth stocks have been higher than for low growth stocks, albeit that this has been more consistent in the EU than in the US. Growth stocks’ margins have been cyclical though – counterintuitively more cyclical than margins for low growth stocks. Further investigation reveals there is a significant difference between the aggregate net profit margin for US technology stocks and the median net profit margin for US high growth technology stocks (see chart below). While indeed the aggregate sector profitability has steadily and significantly improved, the median profit margin for US high growth technology stocks has been cyclical and resides close to its 20-year average. The cyclical profitability of the median high growth technology stock has been an important driver in growth stocks’ profitability.

- These fluctuations in profitability shed another light on the periods with high relative valuations shown above. The PE premium expansions were not only due to relative performance, but also at times because of growth stocks’ weakening profitability. In the US, there are two periods in which growth stocks showed weak margins, roughly coinciding with two peaks in relative valuation. In Europe, only one such period with weak margins and peak valuations stands out. Interestingly, the decline in the median profitability of US technology growth stocks around the GFC did not have much impact on growth stocks’ relative PE at the time, as their weight among growth stocks was less significant then.

Source: DPAM, Factset, MSCI – June, 2023

Volatility is the second dimension of quality that we investigate for growth stocks. The chart below shows the difference in the median beta of high and low growth stocks.

- It can immediately be seen that the beta of high growth stocks is typically higher than the beta of low growth stocks – especially in the US.

- Importantly, during the two most severe crises – the GFC and corona-crisis – the difference in beta tended to vanish or even invert. Still, higher betas also manifested themselves in down markets, such as the first years of the new millennium and 2022.

- Growth stocks’ relative beta is currently near the highest levels witnessed in over 20 years. This is consistent with underperformance during the market decline in 2022 and outperformance during this year’s market increase.

Source: DPAM, Factset, MSCI – June, 2023

GROWTH’S SIZE

Megacap growth is a term coined to refer to some of the largest US companies by market capitalisation, featuring high growth characteristics. We now investigate the link between expected growth and market capitalisation.

In the charts below, we plot the aggregate benchmark weight of the top decile growth companies in dark green. The aggregate benchmark weight of these companies averaged 9.8% in the US and 8.9% in the EU over the last five years. As randomly selecting 10% of the benchmark constituents would result in an average aggregate benchmark weight of 10%, we conclude that there has been, on average, no link between high growth expectations and a company’s market capitalisation over the last five years. However, we can observe that there has been a large fluctuation: In 2018, US high growth companies tended to be large caps, while the opposite was the case a few years later. Today, the chart gives a neutral reading.

Source: DPAM, Factset, MSCI – June, 2023

Intuitive as the previous analysis may be, its shortcoming is that it focuses exclusively on the companies with the highest 10% growth. The largest companies may have above-average growth expectations – just not in the top decile of the universe. To address that, we investigate the rank correlation between companies’ expected revenue growth and market cap. This confirms that there was no statistically significant correlation between the two factors.

The correlation has been more often positive than negative, especially after the GFC. Logically, there is a link between the correlation and past relative performance. In the spring of 2022, for instance, growth companies tended to be smaller after significant underperformance.

MARKET CONCENTRATION AND GROWTH

With this year’s narrow US market breadth, much attention has been paid to increasing market concentration. Indeed, market concentration is particularly high in the US – near a multi-decade high even. The chart below visualises this as it plots the aggregate benchmark weight for the 5% largest companies in the US and EU universe. Five percent of companies account for over 45% of the benchmark weight in the US and around 35% in Europe.

As a final analysis in this article, we now focus our attention on the expected aggregate revenue growth for these very large companies – and compare it with the aggregate growth for the whole market. First, the aggregate sales growth for the whole market is plotted below. It visualises what we know: aggregate revenue growth is structurally higher for listed companies in the US versus Europe, and Europe’s growth is more cyclical compared to the US. Even at a cyclical high, EU revenue growth has had difficulties surpassing US growth. Sector differences obviously are an important part of the explanation.

Source: DPAM, Factset, MSCI – June, 2023

Interestingly, these observations extend to the largest companies, and in an even more pronounced way. The largest US companies have had higher revenue growth expectations than the rest of the US market since 2016. In Europe, it is less obvious to make the same claim, but it is clear that EU megacaps have displayed even higher volatility in growth expectations than the rest of the EU market.

Source: DPAM, Factset, MSCI – June, 2023

This greater cyclicality means that on a few occasions, the largest EU companies have seen higher revenue expectations than the largest US companies. 2022 was one such time.

Source: DPAM, Factset, MSCI – June, 2023

In this article, we have looked at growth stocks and growth expectations from different angles. Firstly, we saw the historically large fluctuations in growth expectations, relative returns, and relative valuations for growth stocks over the last few years. Interestingly, during the corona crisis, as large parts of the economy came to a halt, growth expectations for growth stocks actually witnessed a strong upward jump. This made them a safer place to invest, at a very unusual and uncertain point in time. The abrupt decline in US rates provided another boost to US growth stocks’ relative returns. While today, the growth dispersion and valuation premium for growth stocks are no longer at extreme corona crisis levels, both relative growth and relative valuation are still at high levels. Also, the relationship between relative growth and relative valuation is currently high, particularly in the US.

The adage that growth stocks are defensive has been nuanced in this article. Certainly, in aggregate – when megacaps dominate the analysis, US growth stocks have displayed less volatile and more structural growth, and US technology stocks have seen a rising, relatively stable aggregate net profit margin. Still, the picture changes when looking at the average growth stock. The average growth stock actually experiences volatile growth expectations and volatile margins. Growth expectations for the average high-growth stock are, in fact, counterintuitively more volatile than expectations for low-growth stocks. The median beta for high-growth stocks is currently also higher than the median beta for low-growth stocks, with the difference being historically high – even if their profitability has recently restored.

Large growth companies are thus behaving differently from the average growth company. In this article, we have seen that over the last five years, the companies with the highest growth expectations were, on average, not biased towards large caps. Still, when looking at the growth expectations of the largest companies, they modestly exceeded overall growth expectations in the US since 2016. In Europe, this was less the case. The more cyclical growth expectations were evident, though, for the EU market as a whole, and even more so for the largest EU companies. This cyclicality means that on a few occasions, such as in 2022, the largest EU companies are expected to grow faster than the largest US companies. This is exceptional though, and at the moment of writing, this is no longer the case.

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LET’S TALK ABOUT GROWTH