Market Observations – July 2022
Gravity Always Wins
‘Growth’ company stock prices have undergone a significant re-rating over the past 7 months. After a multi-year period in which the share prices of companies promising high rates of future growth have defied gravity, they have recently fallen precipitously. The question is whether the long bull run for growth companies is over, or whether this is another opportunity to “buy the dip”?
Change in macro environment
The last few months have seen a sharp rise in inflation and expectations of increasing interest rates. The central bank narrative 9-12 months ago was that the inflationary pressures, caused by the Covid-19 pandemic would be transitory and would quickly return to normal. However, supply constraints and demand issues persist, exacerbated by the Russian invasion of Ukraine. Whilst central banks are tasked with keeping inflation under control, they have also been under pressure to continue supporting economic growth through extraordinary monetary support. What we know is that inflation across the world is running hot, with the data showing that we are at 40-year highs as shown in the chart of G7 headline inflation.
Bond markets are telling us that they think the western central banks are behind the inflation curve. Central banks have started to react, but more will need to be done. It will not be an easy task to engineer a ‘soft landing’ – maintaining growth whilst dampening inflation. The rise in inflation has, so far, been caused by supply side factors – rising commodity prices and supply chain disruptions. The concern is that demand led factors, in particular wage increases due to high levels of employment will put further pressure on inflation. Financial conditions may remain extraordinarily loose but a change in language and stance from central banks has already had implications for long duration assets. Long dated bonds and growth focussed equities have seen prices fall as a result.
Is it time to invest in Growth?
What is a growth company? In simple terms a growth company is one which is growing its revenues rapidly and is reinvesting most if not all its profits back into the business to enable it to maintain or increase its growth rate. A non-profitable growth company which typifies ARK and SMIT investments (see chart on Page 1), is one in which it uses other sources of cash (borrowing or equity raises) as it has no profits, to reinvest into its business. Not all growth stocks are the same; some generate profits and positive cash flows (e.g. Microsoft) but some are loss making and are not expected to make profits for many years to come.
With growth stocks down so much year to date, is now a good time to invest in ‘Growth’? If you believe in the long-term value of a company, valuations are materially better than they were at the start of the year. Therefore, it is a better time. However, you must believe the business model is sustainable, as the time of cheap borrowing has gone, and you must also believe that earnings are going to grow. As an investor into a growth company, you are expecting the company to generate larger cash flows far into the future. Therefore, the key components of determining the value of that company are the cash flows the company can generate in the future and the rate at which you discount those future cash flows to work out the present value of the business.
The rate at which you discount the cash flows is based upon interest rates, which have been increasing (rapidly), therefore reducing the present value of future cash flows. Also, markets are worried that an increase in inflation will have an impact upon the profitability and growth of companies and so analysts have started to reduce their expectations of future cash flows. This represents a double hit for the equity stakes in these types of businesses.
All investments involve a degree of risk, but this is particularly acute for pure Growth companies. Understanding why an investment is performing is an important factor in determining whether it can continue. For growth companies the amazing performance of previous years has been due in large part to expansion in the price earnings multiple, the price at which investors are willing to pay for a company. Low interest rates and the enormous amounts of liquidity injected into the financial system by the central banks have made it easier to justify high prices for future profits. Animal spirits then take over and in 2020/2021 investors became overly enamoured with ‘fashion’ stocks, with a compelling narrative about future growth, total addressable markets, and disruption. In 2022 as interest rates rise and central banks tighten monetary policy, the multiples investors are willing to pay has decreased and we have seen valuations decline. The Financial Times highlights the issues in the US Technology sector on 28 June 2022 …
“The US tech sector’s cautious decision to impose a hiring freeze amid slowing growth masks an epic recruitment drive in recent years. Expansion during the pandemic has transformed Big Tech. Between the first quarter of 2020 and 2022, Amazon’s workforce nearly doubled to 1.6mn. Headcount at Facebook’s parent company Meta rose more than 60 per cent to over 77,800. Alphabet’s employee base increased by a third. Giant workforces mean higher fixed costs — a problem when revenue growth falls … According to tracking site Layoffs.fyi, tech sector lay-offs exceeded 138,000 in the second quarter of the year. Fast-growing companies dominate this labour contraction. Coinbase, the listed digital currency exchange, tripled its headcount between the end of 2020 and the start of 2022 to just under 5,000 employees. In June it announced plans to lay off nearly a fifth of its workforce. Tesla more than doubled its full-time employee count, including subsidiary employees, in two years to 99,290 at the end of 2021. Last month boss Elon Musk declared his “super bad feeling” about the economy. Salaried headcount there will drop 10 per cent. Despite recent efforts, US tech companies remain bloated, claimed one Silicon Valley venture capitalist. “The good big companies are overstaffed by 2x,” wrote Marc Andreessen. “The bad big companies are overstaffed by 4x or more.” Those that prioritised revenue growth without margin expansion have had to pare costs. But while the rest of the sector imposes redundancies, Big Tech’s belt-tightening simply restricts new hires. Judging from recruitment sites, competition for workers remains high. Something has to give soon, and that will be their profits.”
Over time, it’s a total return game
If you are successful growth investor your total return will be generated through the price appreciation of stocks. An income, value or more balanced investor will try to generate their total return through a combination of rising share prices and dividends.
Where does that leave us for the outlook for the remainder of 2022 and 2023? As ever, much will depend upon geo-political events, and governmental and central bank actions. Economists’ forecasts vary widely, but the consensus view is that global inflation will moderate later this year and it will take time to get back to ‘normal’. Annual GDP global growth projections for the remainder of 2022 and 2023 have fallen back from 4.6% to 3% since the start of the year and a recession is still a risk at this stage.
We believe our portfolios have the right mix of quality growth funds alongside value, balanced and income managers, which together can capture the total return from the market, whatever the economic outcome, over the long term.
Chris Davis, Chief Investment Officer