In the second of our QD views trailing our upcoming investment companies forum, James Carthew sets the scene for our ‘future of growth investing‘ panel.
At the end of 2021, most growth-focused funds were sitting at or close to all-time highs, but the start of 2022 saw a savage rotation away from growth towards value. The sell-off was precipitous, wiping out the gains that had been made post the COVID panic of March 2020. Some of the most favoured investment companies plunged to significant discounts and many investors appear to have become disillusioned. IPOs and new issuance have dried up, and not just in our part of the market. Will this situation persist or could we see a dramatic recovery?
We have examined the triggers for the switch from value before. It was clear in the summer and autumn of 2021 that inflation was creeping up. In December 2021, the Bank of England edged up the UK base rate from 0.1% to 0.25%. It seemed likely that other central banks would follow suit, but at that stage it was all talk no action.
However, investors were convinced that rates would rise and began to take profits from the growth-focused stocks and funds that had done so well for them over 2021. The selling became self-reinforcing, as prices started to slip and more investors jumped on the bandwagon. This might have been followed by a rally later in 2022 but the invasion of Ukraine changed the game, with new inflationary pressures requiring much more severe action by central banks.
In notes that we have published since, we have highlighted the impact on some of our clients. Chrysalis Investments was one of the worst hit, probably because it had quite a significant exposure to growing but loss-making businesses. We did not publish our initiation note until September 2022 and at that stage the share price had already fallen from 245p at end December 2021 to 69.8p. The NAV had fallen too, although this was less severe – from 237.9p to 163.5p – but sentiment was so against the fund that it had fallen to a 57% discount.
It would be nice to say that we published our note, investors calmed down and the discount narrowed, but it was always going to take a lot more than that. The managers realised that for many of the companies in the portfolio, it might be hard/impossible to raise additional finance until sentiment improved. Their focus switched from identifying new investments to ensuring that the existing ones were financed through to profitability.
The progress that Chrysalis has made on this front has been impressive. In its latest quarterly NAV announcement (published on Monday 31 July, just after the publication of our latest note), it said that 85% of its portfolio was either profitable or funded to anticipated profitability at end June 2023. Encouragingly, its NAV moved higher for a second successive quarter too. That has been driven by the growth of the underlying businesses as well as by recovering valuations of listed comparables.
Edinburgh Worldwide is another client that saw its NAV and share price crumble over the course of 2022. Not only has it been hit by the adverse sentiment towards growth, but also by a seeming aversion towards smaller companies.
There are good reasons for this. For one, the rapid rise in interest rates is putting considerable pressure on companies and consumers alike. There have been genuine concerns about the possibility of stagflation (inflation coupled with a slowing economy). Many of Edinburgh Worldwide’s underlying companies are also caught by the dearth of funding opportunities needed to finance their growth.
You might have though that fears of company failures would be good news for those investors who also focus on quality. Good examples of these are BlackRock Throgmorton and the two Montanaro smaller companies funds (read the latest Montanaro European research report here). However, the figures suggest that a quality focus (buying stocks with strong balance sheets and defensible market positions, for example) has actually been detrimental to returns. It is hard to see the logic here, except that valuation multiples have been hit across the board and quality stocks were quite highly valued going into this.
On the topic of illogical situations, how about the fall from grace of JPMorgan Japanese, which yes focuses on growth and quality, but also is investing in a market where there have been no rate rises and inflation, while picking up, is well below Western levels.
Growth investing worked as a style for so long that there are not that many true value managers left. However, Redwheel – managers of Temple Bar – do fall into that category. The interview with Ian Lance from a couple of weeks ago set out Redwheel’s views on the merits of value versus growth. It feels that the success of growth investing post the financial crisis was largely a reflection of cheap money (low interest rates and government largesse). One counter to that cited by growth managers is technological leaps create opportunities for growth stocks to outperform.
One important strand of Redwheel’s argument is that growth companies tend to underperform because investors tend to be over optimistic about their prospects. We can see the potential truth in this when we try to justify the value of AI-darling stock Nvidia, which is trading on over 19x 2025 forecast revenues and – to me – looks like an accident waiting to happen.
However, if we think about the valuations of the vast majority of the companies in the growth-focused funds that I have been discussing, it would be hard to argue that there is much overexuberance. For that reason, I think that these growth-focused funds will recover more than they already have.
However, we need to think about what the catalyst for that might be. The obvious one would be falling interest rates – a reversal of the conditions that led to the fall. Here opinions are divided – the managers of HDIV, for example, are expecting that central banks will soon be forced to cut rates to tackle a looming recession. The majority seem to think that we are at or near the peak in the US and the UK. After this week’s 0.25% hike in the UK base rate to 5.25%, markets are predicting a peak of about 5.75%. If this does, in fact, mark the peak, then the future of growth investing may look a bit rosier.