While valuations will fluctuate and the environment will change, Baillie Gifford partner Stuart Dunbar explains why growth investing is as important as ever.
Late in 2020 one of our senior analysts wrote:
“I hear suggestions that a rally by value investments is imminent. I disagree. I believe that the opportunity to uncover and invest in great growth businesses is as strong as ever.”
Hubris? Over-confidence? The perspective of someone who has only ever invested in a super-low interest rate environment? What we can say for sure is that shortly after this was written, we saw a big rally in value against growth. The long, slow outperformance of growth that had been evident since mid-2007, and that had exploded upwards in 2020, reversed significantly. Growth, as defined by MSCI indices, underperformed value by 19 per cent in the 18 months to end July 2022. Those at the high growth end of the spectrum saw considerably worse declines in that 18-month period.
Was this foreseeable? Some would argue that it was, as inflation was taking hold even before the Russian invasion of Ukraine. The standard policy response to higher inflation is higher interest rates, which in conventional wisdom reduces the present value of the future profits of companies, raises the cost of borrowing for those who are leveraged and makes it harder for early-stage companies to raise finance. So, markets have reacted pretty much as we would have expected, with the magnitude of the growth correction most severe for those companies with the most future-dependent profitability.
What are we to make of this? That growth will only recover when markets start to anticipate lower inflation and lower interest rates? To some extent this is probably true and we may have seen the beginnings of it as recession looms over further interest rate increases. But here’s the thing – at least at Baillie Gifford – we don’t think any of this actually matters very much.
All growth is not equal. Some growth companies are indebted, some aren’t. Some have entrenched competitive advantages and therefore pricing power, some don’t. Some are creating whole new business models and products, others are locked in a fierce battle to undercut their competitors in the face of rising costs. Some earlier stage companies are well-funded and have a path to profitability, some have flaky business models and in a different funding environment would never have got off the ground. Some are cashflow positive, some continue to be reliant on now harder-to-secure external funding.
On the value side, some companies are cheap because investors have become hugely myopic and risk-averse. Quite a few growth stocks have become value stocks in the past 18 months, without any real change in their operational prospects. Some other ‘value’ companies are cheap because they are in irreversible decline as their business models or products are replaced by newer, better ones.