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- Sometimes, the seemingly ‘obvious’ conclusions that markets jump to are wrong.
- Disruptive, innovative growth stocks can often handle inflation well.
- Volatility is the price we pay for accessing higher long-term returns.
“…markets weren’t efficient at finding the truth; they were just very efficient at converging on a conclusion – often the wrong conclusion.”  Ben Horowitz
The good news is that, based on our estimates, there has only been one other occasion in the last decade (December 2018) where the outlook for returns from innovation-orientated growth stocks has been this compelling on a five-year view. At a sector level, enterprise value-to-sales multiples for the fastest-growing software-as-a-service and internet platform stocks have fallen to lows last seen at the height of the pandemic panic and back in December 2018.
The bad news, of course, is that getting to this point has been painful ride for investors in these kinds of stocks – and that includes our fund and our clients.
Median EV/Forward Revenue (Consensus 24 Months Out)
Inflation fears were the trigger for the sell-off in innovative growth stocks
The trigger for this dramatic shift was an assessment that inflation is not a short-term problem (related to bottlenecks in supply chains) but a longer-term problem resulting from excessive liquidity.
- The traditional story is that inflation tends to benefit ‘value stocks’ – particularly energy stocks, financial services, industrials and materials.
- At the same time, rising discount rates (higher bond yields) reduce the present value of a company’s future cashflows, hurting ‘long-duration’ assets. This includes innovative growth stocks, which are consciously sacrificing their short-term profitability to aggressively invest in future growth.
Jumping to conclusions… The pushing of algorithmic ‘panic buttons’ results in overly crude (and sometimes incorrect) moves in share prices
The rotation has been intensified by the fact that stock markets have become heavily driven by factor investing and algorithms. As we discussed before, this becomes more extreme during a crisis. A survey by JPMorgan suggested that, at the peak of the coronavirus panic in March 2020, more than 60% of large trades in the equity market (for ticket sizes >$10m) were executed by algorithm. Back then, only two things seemed to matter about a company in the eyes of these algorithms: cash on hand and its rate of cash burn. In a few weeks, many stocks fell by 50-75% based on this ‘obvious’ trade.
Unfortunately, the seemingly obvious conclusion these simplistic trades jumped to was wrong: many of the companies whose share prices fell furthest were medical technology stocks or software businesses which benefitted from the social and economic changes hastened by Covid-19. The truth was somewhat different to the crude calculations of the algorithm. This time, the ‘obvious’ conclusion the market seems to have jumped to is that:
- Low-multiple stocks with positive short-term earnings momentum are good (particularly if they are large caps).
- High-multiple stocks that are sacrificing profits to invest in long-term growth are bad (particularly if they are small caps).
This means low-multiple stocks in areas that we believe are certain to be disrupted – such as energy, (traditional) auto manufacturers, old economy industrials and financial services – are outperforming along with mega-caps generating high cashflows today.
But many disruptive, innovative growth stocks can actually handle inflation well
We are not macro investors but – for what it’s worth – we think inflationary pressures will likely slow from here as supply chain issues begin to be resolved, inventories rise, stimulus payments end and as year-on-year comparisons get tougher.
If, however, inflation does prove to be persistent…
- We invest in high-margin businesses with pricing power. This means most will be able to pass on any cost increases (wages or input material costs) through price rises.
- They have very strong balance sheets, with very high net cash levels on aggregate (so rising interest rates actually means their interest income increases).
- Most are free cashflow generative. Those that aren’t could be if they choose to invest less in their own growth.
In short, all of our holdings are resilient to inflation and our analysis suggests they are at very low risk of financial distress. They are all positioned in structurally growing markets. So although their relative growth rates may fall in the short term versus cyclical stocks that are benefiting from higher commodity prices, they should handle inflation well in an absolute sense.