November 2022 / U.S. EQUITIES
Navigating a Tough Environment for Growth Stocks
Amid volatility, focus on what drives stocks over the long term.
- The outlook for inflation and interest rates appears likely to drive markets and the economy in the near term.
- Investors could be tripped up by the prevailing uncertainty and lose sight of long-term opportunities in growth stocks.
- We focus on the rare companies that we think can sustain a high level of earnings and free cash flow growth. Those qualities should matter over the long run.
The first three quarters of the year were painful for many asset classes. Growth stocks especially were hit hard. Stubbornly high inflation, which reached levels last seen in the late 1970s and early 1980s, and the Federal Reserve increasing interest rates in response were key headwinds. Both inflation and rising interest rates erode purchasing power and, as a result, tend to pressure stocks and bonds. Russia’s invasion of Ukraine, an energy crisis in Europe, and the lingering effects of the worst pandemic in more than 100 years also complicated matters.
Further volatility could be in the cards for stocks as the effects of inflation and tightening monetary policy filter through to the economy and corporate earnings.
In our efforts to add value for clients, we remain focused on those rare companies that we think, near-term challenges aside, can sustain a high level of earnings and free cash flow growth. Those qualities should matter over the long run because a company’s stock tends to follow the financial performance of the underlying business.
Inflation and Rising Rates Pressure Valuations and Earnings
Inflation and rising interest rates tend to pressure asset prices by reducing the present value of future cash flows. Growth stocks have typically exhibited greater sensitivity to these factors because investors have demonstrated a willingness to look further into the future when evaluating a company’s prospects. The strong runup in growth stocks during the pandemic may also have made them more vulnerable in a pullback.
Much of the pronounced weakness in growth stocks and the broader market has stemmed from valuation compression, as opposed to a deteriorating outlook for corporate earnings (Figure 1).
Breaking Down the Breakdown in Stocks
(Fig. 1) Bulk of weakness has come from valuation compression
Depending on the duration and magnitude of the Fed’s rate-hiking program, the price portion of the price-to-earnings multiple could remain under pressure.
On the positive side, this leg of the level-finding process seems to be farther along. Growth stocks could return to favor when inflation appears to be trending lower and the Fed might slow the pace of rate increases.
Inflation and Fed policy should also shape the outlook for the economy and corporate earnings, which, in turn, could drive volatility. By increasing interest rates, the central bank seeks to tame inflation through higher borrowing costs, which can slow the economy by prompting consumers and businesses to curb spending and investment.
The big question is whether the central bank can engineer a soft landing for the economy: a goldilocks environment where inflation is not running too hot and growth is not running too cold.
Healthy employment trends and consumer balance sheets in the U.S. suggest that we may experience a recession of a magnitude typical for the business cycle—as opposed to something akin to the 2008–2009 financial crisis. Still, we need to be wary of the potential worst-case scenario: an environment with elevated inflation, higher unemployment, and stagnant economic growth. The Fed faces a tough challenge in that the effects of its interest rate hikes take time to show up in the economic data, potentially increasing the risk of tightening monetary policy too far.
Not all companies will be affected equally by an economic slowdown. Growth stories that are less sensitive to the economy could become more appealing on a relative basis.
Balancing the Short Term and the Long Term
What gives us confidence in growth investing over the long term? The extended runup in growth stocks that occurred in the aftermath of the global financial crisis was supported by meaningful increases in free cash flow per share, not just expanding valuation multiples (Figure 2).
Growth Stocks Have Exhibited Strong Fundamentals
(Fig. 2) Cumulative change in key financial metrics
We believe that some of the powerful trends that have driven outsized growth remain intact and should have room to run, even if these stories may seem old hat to many investors.
Consider the shift from data centers that information technology (IT) departments build and administer internally to cloud-based infrastructure maintained by a third party. This migration started almost 15 years ago but remains at only 10% to 15% of the addressable market, by our estimates. The move to cloud-based platforms and infrastructure could be a multi-decade growth story.
Transitioning data centers and workloads to the cloud saves businesses money by lowering their IT costs. And these investments can also result in meaningful efficiency and productivity gains. The pandemic underscored this point, as employees shifted to remote work seamlessly. Access to low-cost computing power via subscriptions that can be scaled up or down also tends to encourage innovation. In our view, this potentially durable tailwind may benefit established companies, including Microsoft and Amazon.com.
We were big believers in the transition to electric vehicles (EVs) a decade ago and regard this trend as potentially one of the most compelling growth stories of the next 10 years. The size of the market could be significant. Even with a pandemic and significant supply chain disruptions, demand for light vehicles in 2021 exceeded 17 million units in North America and totaled more than 78 million globally.1 The tailwinds for EV demand appear to be strengthening, thanks to supportive government policies and growing awareness of the need to reduce greenhouse gas emissions.
But exposure to a compelling growth trend is not enough. A nuanced understanding of individual companies and industries is critical. We favor EV-focused carmakers that we believe offer compelling product lineups, already have models rolling off their assembly lines, and lack the financial and operational baggage carried by legacy auto companies.
Long-term tailwinds aside, investors must also account for some sensitivity to the economic cycle. Therein lies the potential risk in this environment—and the potential opportunity. The market is often quick to respond to the pace of earnings or cash flow growth in the near term. However, the market may struggle to gauge the potential durability of this trend over a longer time frame.
Potential Opportunities Beyond the Biggest Stocks
At the end of September, the five largest companies by market cap accounted for roughly 22% of the S&P 500 Index and 38% of the Russell 1000 Growth Index.2 This high level of concentration means that large-cap growth investors’ relative performance often hinges on making the right call on a handful of the largest stocks: Apple, Microsoft, Amazon.com, Tesla, and Alphabet (Google’s parent company).
We remain very thoughtful about our positioning in the established tech giants. Key considerations include:
- How effectively they are investing in growth initiatives,
- The levers they could pull to create value, and
- The extent to which they are returning capital to shareholders.
These entrenched businesses have advantages of scale, but constant due diligence is required to evaluate whether they can overcome the law of large numbers. Achieving a robust rate of earnings or cash flow growth becomes more challenging off a large base.
Albeit painful in the near term, the difficult economic environment should expand the opportunity set by creating some coiled springs, or names where the mismatch between valuation and potential growth may create a compelling risk/reward profile.
In managing the strategy, we are always on the lookout for companies that we believe are responding to the difficult environment in ways that can create value over a longer time frame.
Investors need to remain patient amid the prevailing uncertainty to avoid being tripped up and losing sight of the longer-term opportunities in high-quality growth stocks.
T. Rowe Price Beyond the Numbers
Hitting the Road
Meeting with management teams from private and public companies and visiting their facilities are critical to our due diligence.
Nothing beats going on the road to meet management teams and visit their facilities. We have stepped up our travel as we search for insights and opportunities. Being on the ground helps us to build an understanding of a company’s culture, operational prowess, and other intangibles that we believe can be important to potentially durable growth.
We are finding more opportunities in the public markets. However, the challenging environment seems to have made private companies more willing to meet, even if they are not actively seeking funding. These visits can provide useful insights into how an industry might be evolving and possible future areas of disruption.
The following risks are materially relevant to the portfolio:
Style risk—different investment styles typically go in and out of favor depending on market conditions and investor sentiment.
GENERAL PORTFOLIO RISKS
Capital risk—the value of your investment will vary and is not guaranteed. It will be affected by changes in the exchange rate between the base currency of the portfolio and the currency in which you subscribed, if different.
ESG and sustainability risk—may result in a material negative impact on the value of an investment and performance of the portfolio.
Equity risk—in general, equities involve higher risks than bonds or money market instruments.
Geographic concentration risk—to the extent that a portfolio invests a large portion of its assets in a particular geographic area, its performance will be more strongly affected by events within that area.
Hedging risk—a portfolio’s attempts to reduce or eliminate certain risks through hedging may not work as intended.
Investment portfolio risk—investing in portfolios involves certain risks an investor would not face if investing in markets directly.
Management risk—the investment manager or its designees may at times find their obligations to a portfolio to be in conflict with their obligations to other investment portfolios they manage (although in such cases, all portfolios will be dealt with equitably).
Operational risk—operational failures could lead to disruptions of portfolio operations or financial losses.
The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”) and has been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.
London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2022. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.
Copyright © 2022, S&P Global Market Intelligence (and its affiliates, as applicable). Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact.
This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass.
The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.
It is not intended for distribution to retail investors in any jurisdiction.
Canada – Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.
© 2022 T. Rowe Price. All Rights Reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.