2023-12-22 05:29:43 ET
Summary
- iShares Core S&P U.S. Growth ETF is a growth-focused ETF holding close to 500 growth stocks, including big tech companies.
- The fund's performance this year has been driven by multiple expansion rather than earnings growth, raising concerns about valuations.
- Apple and Microsoft, the top holdings of IUSG, have seen significant stock performance from P/E expansion rather than earnings growth.
- Investors should be cautious moving forward but also shouldn't bet against this growth stock when the sentiment is so strong.
iShares Core S&P U.S. Growth ETF (IUSG) is a growth-focused ETF as its name implies. It holds a basket of growth stocks whose companies are mostly based in the US. The fund holds close to 500 growth stocks, including the magnificent seven and other big tech companies. While the fund's performance has been stellar so far, much of its performance came from multiple expansion rather than earnings growth which warrants some caution.
2023 has been a great year for growth stocks after they got demolished in 2022 because of rising interest rates driven by high inflation. This year, rates continued to rise for the first few months and then stopped rising in the second half of the year, but growth stocks have been on a roll since January 2nd as the market has been anticipating a rate cut from the Fed since the beginning of the year. The anticipated rate cut didn't come yet but at least during the December meeting the Fed has signaled that it is willing to cut rates by as much as 75 bps sometime during 2024 (most likely in the second half). This was more than enough to fuel another rally in an already overheated market and drove Nasdaq 100 index (QQQ) to new highs.
Growth stocks certainly had a stellar year but this also raised concerns about this market segment's valuations. During the year, growth stocks didn't post much of an earnings growth, but their stocks still rallied hard, indicating that most of their performance came from multiple expansion (also known as P/E expansion).
IUSG holds close to 500 growth stocks which include the "usual suspects" such as the magnificent seven and other big tech. Magnificent seven seems to carry about 50% of the fund's total weight which makes the fund top heavy and super dependent on FAANGs.
Let's take the biggest holding of IUSG which is Apple (AAPL). Apple currently accounts for 13% of the fund's total weight, so it's a pretty significant portion of the fund and one of its main drivers of performance. This year Apple's earnings grew by only 1.92% while its stock price jumped by 49.93%. As a result, Apple's P/E ratio jumped by 49.69%. In other words, almost all of Apple's stock performance this year came from multiple expansion while none came from actual earnings growth. Currently, Apple trades at a P/E of 35 indicating annual growth rate of 10-15% even though its actual growth rate is much smaller.
When we zoom out and look at the last 5 years, we see a similar but less drastic trend. Apple's share price is up almost 400% and close to half of this performance came from P/E expansion as Apple's P/E rose by almost 150%. During the same period, Apple's earnings grew by 63%. Basically, Apple's P/E grew from low teens to mid-30s during the same period even though its earnings growth actually decelerated.
Apple is not the only example either. The fund's second biggest holding is Microsoft (MSFT) which accounts for 12% of its total weight. Basically, Apple and Microsoft claim 25% of the fund's total weight. In the last 5 years Microsoft's net income rose by an impressive 53% but during the same period the company's stock price rose by an even more impressive 267%, half of this gain accounted by P/E expansion which came at 130%. Microsoft is another company whose P/E rose from low teens to mid-30s.
Now we can come up with different reasons as to why this happened. For example, many people say that Apple now deserves a higher P/E because it transformed itself from a hardware company that produces laptops and phones to a digital services company that sells subscriptions and online services in its app store. Similarly, people argue that Microsoft deserves a higher P/E because it transitioned from selling PC operating systems to selling cloud based subscriptions which help it gain recurring revenues and profits. This is all great and maybe justifiable but if these two stocks' performance in the last 5 years is mostly explained by multiple expansion alone, how likely it is to be repeated. Can Apple or Microsoft's P/E jump from 35 to 100 in the next 5 years like it jumped from 13 to 35 in the last 5 years?
There isn't anything wrong with a company posting P/E expansion but you don't want your stocks to entirely rely on P/E expansion for its performance because it may not be sustainable. P/Es can't expand and expand forever and at some point earnings growth has to catch up with the P/E expansion.
The trickiest part about investing is that you have to figure out not only which companies will be most successful but also which companies investors will bid up. A company could double its earnings but investors might sell it off and another company could see its earnings decline but investors might still reward it with a higher price. Last year when we were in a bear market investors heavily punished companies like Nvidia ( NVDA ), AMD ( AMD ) and Meta ( META ) even though they were posting impressive growth. This year they are rewarding the same companies with the same growth rates. You may be able to figure out which companies will perform good in a year but the harder part is figuring out which companies will get rewarded and which companies will get punished by the market for their successes and failures. This is why most investors would be better off investing in a fund than picking stocks so that they are sufficiently diversified.
The funny thing is that multiple expansion is not limited to a few growth stocks either. Since October of 2022, S&P 500's P/E expanded from about 20 to 27 which is a P/E growth of 35%. Basically all of S&P 500's performance since October came from multiple expansion alone. Historically speaking, markets have P/E expansions like this when interest rates are dropping because bond yields drop and people sell bonds to buy stocks in order to boost their income. It's very rare for S&P 500 to post a 35% P/E expansion while interest rates are rising which they were for the most of last 15 months.
Overall markets and growth stocks are now pricing in a 0% environment similar to what we had in the second half of 2020 or the year of 2021. In order for the current valuations to make sense, interest rates would have to drop by not only 75 bps but much more than that. Currently the overall market has an earnings yield of 4% (inverse of P/E) and growth stocks have an earnings yield of 2.65% (inverse of P/E) while bonds still yield 5.5%.
So growth stocks are currently very expensive but valuations alone can't cause them to correct in any meaningful way. Many people expect growth stocks to crash because they are too expensive but if it were so it would have happened already since growth stocks have been expensive for quite some time by now. In order for tide to change you also have to have sentiment shift in a major way and this may not happen for some time. This is why I said above that you have to be good at not only predicting a company's prospects but also investors' sentiments about that company's prospects which is nearly impossible to do.
Then what do you do with this fund? This depends on your time horizon. If you are close to retiring or already retired you might want to trim your exposure or maybe sell some covered calls just to protect yourself a bit and reduce your cost basis. You don't want to completely get out either and you certainly don't want to be shorting anything while the sentiment is so strong. If you are younger and have many years ahead of you, I'd keep holding what you already have and ride it up but probably don't add to your positions while valuations are this high. Perhaps keep holding and add when there are dips along the way.
For further details see:
IUSG: Strong Sentiment But Stretched Valuations