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. Understand