Friday Highlight  

Growth stocks could be nearing turning point

Growth stocks could be nearing turning point
(Photo by Chris Hondros/Getty Images)

The Federal Reserve’s words and actions have gone a long way towards reducing the open-ended fear that gripped markets earlier in the year.

The outlook for growth stocks as inflation remains high

Investors are still concerned about inflation, but recent trends suggest they believe the Fed will do whatever it takes to get it under control.

The Fed will raise rates until growth slows and inflation cools, and we are seeing early signs that inflation may be peaking.

Article continues after advert

Historical patterns of the past four Fed rate hike cycles going back three decades show that growth stocks underperformed when rate hikes were initially announced and/or commenced.

However, once the rate hike cycle is underway and economic data softens, growth stocks resume leadership. Recent market action suggests growth stocks could be bottoming and nearing a turning point.

How valuations factor into outlook

Valuations are a prominent positive feature in the current outlook for growth equities.

The growth stock valuation premium versus the broader market peaked at 38 per cent in 2021.

That premium has been cut nearly in half since then, putting it back in line with its long-term historical average.

Likewise, growth’s valuation premium relative to value retreated significantly from the high it reached during the Covid-19 market rally.

Price-to-earnings multiple compression in growth stocks reduced the valuation relationship below even long-term historical averages, suggesting a favourable outlook with attractive upside potential.

Growth stocks and the slowing economy

The companies most exposed to the Fed’s efforts to reduce aggregate demand come from cyclical, economically sensitive sectors.

Companies that capitalise on secular growth trends represent promising opportunities in conditions like these because their business fortunes do not rise and fall with the economic backdrop.

We are interested in companies that are selling something consumers cannot do without or that other businesses really need, particularly in the technology arena.

We also like stable growth companies with recurring revenue – the kind of business models that offer good visibility.

Companies that capitalise on secular growth trends should stand out in this environment because they are positioned to execute even as economic headwinds swirl.

Capitalising on compelling secular trends

Certain secular megatrends have been reshaping how we live and conduct business for years now.

The digital transformation of the enterprise is still in its early stages and the ability to leverage data continues to expand.

Direct-to-consumer business models increase efficiency and profit potential for the companies that embrace them while offering convenience and cost savings to customers.

Efficiency and convenience are also common characteristics among technology enablers, such as companies that facilitate electronic commerce.

To capitalise on these trends, we look for innovative companies offering unique products or services that solve real-world problems.

We want dynamic companies with expanding secular demand that conduct business in large and growing markets. And, of course, we want companies that are fundamentally sound, with durable growth potential evident in revenue and earnings trends.

One of these growing markets is in electric vehicles – an area that is booming.