Why have innovative growth stocks fallen so far?

• 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.” ^[1] 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:  

1. Low-multiple stocks with positive short-term earnings momentum are good (particularly if they are large caps).
2. 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.

The market seems to be drawing a false equivalence between today’s innovative growth stocks and the TMT bubble

Today, market consensus, commentary and algorithmic traders seem to be equating so-called ‘profitless growth’ companies (software as a service and medtech companies) to 1999 tech and telecom bubble stocks which were valued on eyeballs.

The truth as we see it is that companies that are delivering rapid revenue growth in large addressable markets and which offer compelling unit economics (even if it is not yet apparent in financial statements) are a very different proposition.

Long-term deflationary forces haven’t gone away

Moreover, despite the current panic around inflation, the case for structural deflation is still strong. Multiple technology trends are still in their early stages and are following Wrights Law: when production is scaled up, efficiencies tend to bring down per-unit costs at a predictable ‘learning rate’.

We see this happening in:

• Solar power
• Wind power
• Electric batteries
• Genome sequencing
• Robotics
• AI/ML (artificial intelligence and machine learning)

We expect the declining cost of these technologies to stimulate rapid adoption and unlock significant economic value as they create a disruptive shift in the basis of competition. Many of the incumbent ‘value’ stocks and sectors will fall victim to that disruption.

Past experience suggests that companies that can deliver compound growth of 20% per annum over the next three years will tend to do well over that timeframe… regardless of what path inflation takes. Although we need to await confirmation from the earnings season, we estimate that the weighted average revenue growth from our holdings in 2021 will have been 35%, compounding the 39.3% revenue growth they delivered in 2020. 

Consensus estimates suggest that the two-year forward revenue compound annual growth rate for our portfolio is +29% (we suspect this is too conservative). Yet despite the high rates of revenue growth that have been delivered and which are expected to continue, our holdings’ share prices have declined significantly.

With babies having been thrown out with the proverbial bathwater, we believe this is a stockpickers' market. Based on our long-term discounted cashflow-based growth forecasts, many of our holdings now trade at a fraction of their peak valuation levels… 

We accept that our rapidly growing companies may get cheaper in the short term

We offer one caveat to the optimism we feel about the return potential of our stocks from these levels: although we believe that our companies can handle a period of inflation, an intensification of market’s worries would likely place valuations of the longer-duration stocks in which we invest under renewed pressure.

This is partly a myopic market reflex (and a function of algorithmic trading). And, in part, it reflects commonly held beliefs about economic theory. Whether the theory is true or not is irrelevant in the short-term, because the market believes it to be. 

For as long as worries persist about inflation’s effect on long-duration assets, the only thing for our stocks to do will be to prove over time – via their results – that they deserve to be treated differently. In the meantime, if revenues (and the prospects of future cashflows) continue to grow rapidly even as share prices fall, their shares will rapidly de-rate.

We believe this is what has been happening; we also believe that it provides a very promising set up for outperformance by growth stocks over the next three-to-five years. As uncomfortable as it might feel today, we must remember that volatility is the price we pay for accessing higher long-term returns.

But the strongest bull markets tend to climb a wall of worry

A wall of worry has been built from the idea that we have seen a bubble in growth stocks (high multiples = high valuation) and that rising rates inevitably make growth stocks bad investments (because the rising cost of capital will permanently reduce their valuations and slow their growth).  

We remind ourselves, however, that the strongest bull markets tend to climb wall of worry. So we actually find it reassuring that, in contrast to the late 1990s, there appear to be so many things to worry about. Volatility and fear are again providing an opportunity to invest in powerful disruptive growth businesses that are solving big problems in big markets. It may not feel like it, but this is a good time to be a growth investor.

Craig Bonthron co-managers the Artemis Positive Future Fund

^[1] Ben Horowitz. The Hard Thing About Hard Things: Building a Business When There Are No Easy Answers

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