PLDR - Growth Stock Rout Resets Valuation Landscape

Summary

• The sharp declines have dramatically changed the valuation landscape.
• Paying too high a premium for safety could backfire if market trends shift again.
• We believe growth stocks’ valuations are far more attractive today than they were a year ago.
• Active investors should focus on companies with resilient business models and high, consistent profitability, based on metrics such as return on assets and return on invested capital.

By Frank Caruso, CFA

Sharp Declines Begin to Open Quality Growth Opportunities

It’s been a tough year for investors, particularly in growth stocks. But the sharp declines have also dramatically changed the valuation landscape. Long-term investors can now find attractive entry points for companies with quality businesses that can navigate a growing list of uncertainties and deliver solid growth over time.

Growth stocks have fallen sharply this year. Even after modest gains in the third quarter, the S&P 500 Growth Index was down by 28.2% this year through September 23, while the S&P 500 declined by 21.6%. Even before September’s declines, the forward price to earnings ratio of the Growth Index had fallen to 20.4× through August 31, taking its valuation spread versus the value index close to its 10-year average for the first time in nearly four years.

Highfliers Return to Earth

During the growth-stock rout, high-flying technology stocks were hit hard. The Goldman Sachs Non-Profitable Technology Index tumbled nearly 70% from its peak last year to the end of August. Investors have clearly fled from the crowded trade in stocks promising extremely high future growth, often with questionable managerial and competitive differentiation to build and sustain a great business.

But where have they gone? Among other things, this year’s flight to safety led many investors to shift toward low-volatility stocks, such as utilities and consumer staples, which offer more stable trading patterns for turbulent times. In some cases, these stocks have become quite expensive. Of course, there are good strategies for capturing lower volatility stocks at attractive valuations . But paying too high a premium for safety could backfire if market trends shift again.

Sustainable Profitability Points to Solid Growth Companies

We believe growth stocks’ valuations are far more attractive today than they were a year ago. Yet at the same time, macroeconomic and market conditions are especially challenging. Rampant inflation is prompting interest-rate hikes that are compressing equity valuations, with growth stocks disproportionately affected. Consumers and investors are bracing for a recession.

What should growth investors do in this environment? We think active investors should focus on companies with resilient business models and high, consistent profitability, based on metrics such as return on assets and return on invested capital. These are good signs that a company has sturdy underlying business drivers and is capable of self-funding investments to support long-term growth.

It may be harder to find companies like these today. But they’re likely to be trading at much more attractive valuations than in recent years. Positioning in growth companies with these features can help create a portfolio that is built to navigate today’s tougher business environment—and reward investors with better risk-adjusted returns over time.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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