Growing Pains

Growing Pains

Being a growth investor hasn’t always been easy of late, but better times could be ahead if the current rate-hiking cycle is truly near an end.

Members of AGF’s Investment Management team sat down recently to discuss their thoughts on the bifurcation of performance in growth-oriented stocks this past year and why short-term challenges can end up being long-term opportunities for those who are patient and take a disciplined approach.

Questions and answers that follow have been edited for clarity and length.

What has been the backdrop for growth investing since interest rates started to climb almost two years ago?   

Martin Grosskopf (MG): Growth companies that make longer-term investments are typically challenged as rates go up. And the market has punished growth companies through this cycle that tend to have the least free cash flow. This includes many small and mid-sized companies focused on the sustainable themes that I invest in, many of which represent ambitious secular opportunities but lack capital and are being forced to drain a good part of their free cash flow to fund projects.

In other words, too many investors are just completely ignoring these businesses and are chasing instead larger capitalization growth names that have much smaller capital needs and still generate considerable free cash flow. As such, it’s become a bifurcated growth market to some extent, with some large caps seemingly immune from higher rates, but small and mid-caps running into challenges.

Mike Archibald (MA): It’s been a good environment in some ways, but extremely challenging in others. On the positive side, there have been a lot of pressures in other areas of the stock market – including the regional U.S. banking crises, the runup in rates that put a lot of pressure on interest rate-sensitive sectors and more – which has made the case for growth ideas more compelling. Yet, on the other hand, the increase in interest rates has also put downward pressure on valuation multiples for many growth stocks, all while half a dozen or so large-cap technology companies have captured most of the market’s attention (and dollars), which has pulled money away from other high-quality growth names in the process.

So, it’s hard to say it’s been a bad year for growth investing. It really depends on your style and/or approach. But it’s definitely been a narrower market for growth, one that has required a focus on larger companies with strong balance sheets for the most part.   

Tony Genua (TG): I like to think of what we’re experiencing so far this decade as being similar to the 1920s, which was a roller coaster for stocks. Investors have been through a number of twists and turns since the beginning of the pandemic, and just in the past two years, we’ve gone from suffering through a difficult bear market to a recovery that has major equity indexes like the S&P 500 once again flirting with all-time highs.

Granted, to the extent that rates have gone from low to high over the past two years, it hasn’t been a very good environment for the majority of growth stocks. And as Martin alluded to already, the rebound has been fuelled mostly by only a handful of stocks, specifically some of the world’s largest “tech giants” who have been rewarded for having strong recurring revenues and higher cash balances, as well as for being connected – in most instances – to the burgeoning trend of artificial intelligence (AI), which has been a major catalyst.

MG: To that end, when I look at the electric vehicle (EV) universe of stocks, sentiment has been abysmal for most of the names, mainly because fundamentals are not very good. Yet the EV market leader is up something like 70% because it’s linked to the handful of tech names that investors have been piling into over the past year. The dynamic in and of itself is sucking capital away from other growth opportunities.

MA: The challenge of the big tech names is that it has been a gravitational pull away from almost all other equity investments, styles and sectors. Those stocks have done so well – having very strong balance sheets and decent growth themselves – that they have overwhelmed other, generally smaller, growth names. And because they are large components of the index, as they go up, more and more managers are forced to participate in those names. This performance has masked a much less robust equity market under the surface.

How has your management style changed considering some of the difficulties you have faced?

TG: A year like this can be humbling, but it has not changed my approach one iota and we will continue to focus – among other things – on growth stocks with fundamentals momentum as opposed to just price momentum. In particular, we’re interested in companies that have earnings growth that exceeds their price appreciation, which hasn’t been the case for some of the market’s best performing names this past year.

MG: I don’t think it’s reasonable to anticipate a specialty mandate that is focused on sustainable themes like mine to just suddenly adopt a different process because the market dynamic is difficult. We take our lumps in certain parts of the cycle, but where we lose the confidence of our clients is by adding names to our universe that weren’t there before.

I’ve seen that happen in some other sustainable strategies that have done relatively well over the past couple of years, but, to me, it’s a sign of capitulation and the risk is that you miss out on the rebound when the market starts to broaden to the areas that you told your clients you were going to invest in.

MA: In Canada, I’m still looking for “growth compounders,” or companies that have consistently shown an ability to grow sales and profitability metrics over time. These tend to be more mid-cap in size but over time may grow into larger cap companies. We also tend to focus on names with a lower capital intensity profile, higher margins and, where possible, recurring revenues, but pay careful attention to when the forward outlook of high-growth companies starts to slow versus its history and that of its peers.   

Historically, we have found many of these ideas in sectors that include Industrials, Consumer Discretionary and Staples, and Technology, all of which are areas that exhibit above-average growth rates versus other industries and the broader S&P/TSX Composite Index.

MG: I’ll just add that we traded more actively this year than we did in the immediate aftermath of the pandemic when it was important to wait for meaningful data to roll in before making significant changes. It took a while, but there’s much more insight into things like inflationary pressures than there was before and, in some instances, we have re-allocated our capital in the near term. That doesn’t mean we’ve lost sight of the names that we believe are future winners but out of favour today. We just have a bit less exposure to them at this time.

Do you expect more favourable macro conditions for growth investing next year?

MA: It’s a tough call, but it looks like interest rates may have peaked and that inflation should stay well contained and under control at current levels. And if so, that should result in a better backdrop for risk taking, and by extension, growth stocks. The real key here is how the economy evolves over the next six months. If the broader U.S. economy can remain resilient into next year in the face of elevated rates, then the stock market can do well next year. Meanwhile, some areas of the stock market have de-rated so much that they are now starting to offer interesting prospects for appreciation.

TG: We’re entering the new year in a bit of a soft patch regarding economic growth. Canada, for instance, is already near a technical recession, having recorded negative GDP growth in the third quarter. Meanwhile, U.S. GDP in the third quarter of 5.2% is probably unsustainable, while elsewhere globally, countries like China have been struggling. Still, year-to-year, statistics show that equity markets end up higher 75% of the time, so there’s good reason to be positive about 2024. And if we don’t have a major push higher in interest rates from here, the valuation story will be good for growth companies that have above-average visibility and deliver on results.

MG: I believe central banks are close to being done raising rates. At the very least, the volatility associated with the rate-hiking cycle should decline in 2024, which would likely be positive for a broader swath of growth companies. That’s not only potentially good for a sustainable strategy like mine, but the overall economy as well, in my opinion.

TG: This time next year, I would expect us to be talking about a globally synchronized recovery and a broadening out of the market to non-growth names.

What growth themes or trends are you most focused on going forward?

MG: Decarbonization is obviously the biggest overarching theme impacting my strategy, but related to that is the potential catalyst of more government spending being allocated toward sustainability projects and technologies. Take the Inflation Reduction Act (IRA), for instance. I believe this to be a generational piece of U.S. legislation that could end up re-shaping the North American manufacturing landscape despite the near-term concerns associated with cost inflation and project permitting. We believe some companies will benefit enormously from the IRA in the end and want to leave positions in the portfolio to maximize this long-term potential while minimizing the short-term myopia that is hurting some of these names now.

TG: My growth strategies typically focus on multiple themes, including AI, which I started investing in years ago – well before it was popularized. The trend toward sustainability is another theme I like longer-term despite near-term challenges, and several growth opportunities are likely to emerge from the accelerating health and wellness trend, including in areas like precision medicine where interest has already ramped up significantly in GLP-1 drugs that are being used to treat diseases like diabetes and obesity. Finally, re-shoring is another trend to watch over the next few years. It could net potential opportunities in certain Industrials stocks and/or semiconductor companies opening new manufacturing facilities in different parts of the world.

MA: Agreed. I believe themes like re-shoring will continue to provide opportunities going forward for engineering and construction companies as the runway for growth in that space is many years in duration. The backlogs of those businesses are as good as they’ve ever been because global governments continue to ratchet up infrastructure spending around the world.

Ultimately, being a growth investor hasn’t always been easy of late, but we believe better times are ahead for those with patience and a disciplined approach.