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Growth Finally Comes at a Reasonable Price / Growth stocks trading at a discount

22 November 2022 Michele Santangelo, Portfolio Manager at Indepedent Securities
Michele Santangelo, Portfolio Manager at Indepedent Securities

Michele Santangelo, Portfolio Manager at Indepedent Securities

The years following the covid pandemic can be described as “unprecedented” due to the significant amount of volatility, both to the upside and the downside in the markets.

Growth stocks, in particular, were pushed to stratospheric levels only to halve and halve again. Inflation has spiked to levels last seen 40 years ago, forcing central banks around the world to aggressively raise interest rates to contain inflationary pressures.

As interest rates and bond yields have risen investors’ opportunity set for earning a reasonable yield has grown.

At the same time, higher rates increase the discount rates that are used in the valuation of assets, such as equities. The assets that are the most impacted by this are long-duration assets like growth shares.

Slowing economic growth and recession fears have also dampened the general growth outlook, leading to depressed valuations, particularly for high-growth shares whose valuations are tied to their ability to grow top-line revenue into the future.

Markets move further than expected on the way up and on the way down
The headwinds impacting stock markets have meant the Nasdaq Index, which is typically representative of high-growth tech companies, has fallen by 35%. The Nasdaq Index is in deep bear market territory, but the mega-cap technology stocks have masked the true carnage that has occurred for smaller and mid-sized companies. The ARK Innovation Fund (ARKK) is best-known for investing in high-growth companies, it rallied by over 380% from its March 2020 lows only to fall by nearly 80% from its previous all-time highs. At the same time, cloud stocks were 61% off their peak, fintech stocks were 63% off their peak and e-commerce stocks also collapsed by 63%.

Bear markets are painful but fortunes are made in bear markets and not bull markets. This is because assets can be purchased at highly depressed valuations relative to their potential. Current negativity towards growth shares is typical of the short-termism that dominates financial markets and provides an opportunity for investors with a longer-term perspective. At this point, investors need to determine which companies have sustainable business models that are growing despite the macroeconomic headwinds and that can be purchased at valuations closer to the lower end of their historical range.

From growth abundance to growth scarcity
The differences between the current market conditions and the conditions that sparked the stock market rally in 2020/2021 are vastly different. Then market liquidity was high, sentiment positive and growth abundant. The environment has now switched, and growth has become a scarce but sought-after commodity.

The distinction between structural growth companies and momentum growth companies is also important, especially in the current environment, as momentum growth typically ends abruptly. A great example of a momentum growth company is Zoom, the video meeting software that became commonly used during covid. Zoom is a good company and received a big boost from covid. However, Zoom does not have a real competitive advantage, nor any type of moat, and its growth momentum is unlikely to be sustainable.

Structural Growth on Sale
There are a variety of sectors that benefit from structural growth tailwinds. These include software, fintech, blockchain, wellness, clean energy, electric vehicles, agritech, biotech, luxury goods, medical devices and semiconductors. The key within these sectors is to determine which companies are best placed to benefit from these trends and whether they can be bought at reasonable prices that justify their future prospects with a reasonable level of confidence.

We see potential across the size and risk spectrum of growth companies at present. On the large market-cap front, Adobe (ADBE) stands out as a high-quality growth company trading at an attractive valuation when compared to its history. Adobe is the quintessential Software as a Service (SaaS) company, with products that are critical to the digital age. Booking.com (BKNG) is also trading at a reasonable valuation and stands to benefit from the travel spending boom that has emerged post covid.

Within the luxury goods sector, Canada Goose (GOOS) offers a good combination of value, quality and growth. Demand is resilient for luxury goods and Canada Goose’s famous parka jackets remain in high demand across existing and new growing markets. The renowned quality of their products, coupled with the launch of new categories such as shoes and accessories, provide a strong growth underpin.

One sector that remains recession-proof is the cybersecurity sector. The sophistication and frequency of cybercrime continues to grow steadily. The companies that operate in this sector need to have cybersecurity technology solutions that are ahead of their peers. Those that are technologically superior will continue to grow at an attractive pace as customers continue to deploy capital to keep their businesses and their customers protected. Crowdstrike (CRWD) is a great example of a high-growth company that has technological superiority within a growing theme.

Another sector that has incredible potential is Biotech, particularly at current prices. This sector is trading close to its cash levels, meaning investors can buy these companies at the same value as their cash holdings and essentially own their intellectual property for free. Given the high-risk nature of investing in individual biotech shares, we take advantage of these dynamics by investing in the S&P Biotech ETF (XBI). Alternatively, Illumina (ILMN) is a great company within this theme that provides the tools required for genomic testing while controlling over 80% of a growing market.

Asymmetrical Returns for Long-Term Investors
The current environment may be filled with unheralded uncertainty and negativity. However, it’s at this point in the market cycle, after a significant collapse in share prices, that investors who are willing to accept some volatility have the opportunity to buy into wonderful companies at reasonable valuations.

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