Are Growth Stocks Attractive for Post-Corona

Investor-popular U.S. growth stocks are now on sale, raising skepticism as to whether they can still justify valuations with extremely high potential growth. Reflects. But growth-seeking investors can get steady returns regardless of the bubble by investing in quality companies with high-profit levels and sustainable business models.

 

The Russell 1000 Growth Index rose 81.1% from its lows on March 22, 2020, to December 31, 2020. It was driven by a few stocks that benefited from digitization through the Corona crisis, most of the tech companies. However, the momentum seems to be slowing down in 2021. The index, a benchmark for growth stocks, fell 0.8% from the beginning of the year to the end of February, with some of the top constituents falling 15-20% below their recent highs.

 

In 2020, ahead of the recent plunge, speculative movements were prominent in the stock market, from record-breaking initial public offerings (IPOs) to a surge in individual investors. The valuation of hyper growth stocks approaches the level of the dot-com bubble in 2000, according to the “economic value return,” a cash-flow-based indicator that more accurately assesses a company’s basic economic value than revenue-based indicators. (Chart, left figure). In addition, non-profitable deficit companies significantly outperformed profitable companies (Chart, right figure). After all, these trends have further exacerbated the pre-pandemic divergence between corporate valuations and fundamentals.

 

 

 

Many investors have questioned the sustainability of such high valuations, wondering if valuations could not be maintained, especially if interest rates rise or the business environment in other industries improves. There is. The biggest winner under the pandemic will be making comparisons based on the high sales and profits of the previous year, which can make it difficult to meet the high growth expectations of the market. Where should growth stock investors look now? Alliance Bernstein (“AB”) said that companies with strong fundamentals should be noted, as they were attractive when stock prices were rising, given that they would follow the right criteria. Think.

 

True growth begins with sustainable fundamentals

Extreme price movements like today remind us that companies can make extremely high returns even if they are not making steady profits. Of the 15 US growth companies that are “jumping” with average returns of 250% in 2020, eight haven’t made a profit in the last 12 months on a pre-interest / pre-tax basis The profits of the seven companies were insignificant in light of the size of the company. On average, 87% of their corporate value is in the future growth prospects, according to AB research. This suggests that investors rely on their potential for future success, rather than their current success, for almost all of the value of these companies.

 

According to Credit Suisse’s corporate valuation system HOLT, sales of jumping companies are expected to grow by an average of over 20% by 2024. But after that, the trend is probably unsustainable. In fact, high growth in the early days of a company rarely lasts forever. According to HOLT, few of the top 1,000 US leap companies, defined as fast-growing companies in the early stages, saw annual sales growth of 15% five years later. Moreover, sales growth is not a favorable indicator that profitability is stable.

 

However, investors can find large-cap stocks that are achieving higher profitability while achieving more stable performance. Many of these stocks have underperformed their peers, whose stock prices are soaring, but still offer attractive long-term investment opportunities. In particular, it meets certain conditions such as steady return on assets (ROA) and return on invested capital (ROIC), return on equity discipline, durable growth model, and corporate culture that emphasizes vision and accountability. If so, its appeal will be further enhanced.

 

ROA: Long-term perspective

Profitability is often a better indicator than profit level in assessing basic performance. Published profits do not necessarily represent the big picture and can be considered easy for businesses to manipulate. AB believes that ROIC and ROA are excellent indicators of performance growth and sustainability, especially when comparing different companies.

 

ROIC and ROA were particularly helpful when many companies withdrew their earnings forecasts at the peak of the pandemic Both indicators will become particularly important as interest rates rise and discount rates that assess cost of capital and future cash flows are pushed up. Inflation could rise as the economy recovers, which could also increase risk. ROIC and ROA provide an undistorted and objective view of what the company will do after an economic recovery.

 

Reinvestment: Sowing for sustainable growth

It’s important to look at how profitable companies are using their surplus funds. While share buybacks and dividends are attractive to investors, AB believes that companies will be most successful when investing in the future. Strategic reinvestment based on equity capital can generate long-term returns and create true shareholder value.

 

As the economy improves, reinvestment and sustainability will begin to move in tandem. For example, companies that are currently investing less may be more profitable, but their weaknesses may be hidden or they may not be prepared for potential threats to their business model. Sales growth can be misleading when assessing successful growth companies under a pandemic. Investors must make sure that fast-growing businesses are investing adequately to maintain and strengthen profitability in situations where consumer and business behavior is broadly normalized.

 

Corporate Culture: Why Corporate Attitudes Make a Big Difference

Investors must also consider the impact of environmental, social and governance (ESG) issues on corporate profits and growth sustainability. In that sense, corporate culture is of particular importance (see previous article, “Corporate Culture is the Secret to Growth” ). Because corporate culture represents a company’s commitment to diversity, trust, accountability, and vision, all of which lay the foundation for long-term success. Corporate culture is considered an invisible asset, but it has a measurable impact on a company’s performance. For example, companies that have cleared the challenge of ensuring employee safety throughout the pandemic often have a corporate culture that understands why ensuring employee safety underpins a profitable business.

 

Advances in corona vaccination and government support will increase the certainty of economic recovery. Companies with outstanding, sustainable business models will become even stronger after the Corona disaster. And eventually, AB sees the economic recovery benefiting a wider range of growing companies. Maintaining the discipline that stock valuations focus on stocks commensurate with the strength of a company’s fundamentals may be the best way to capture growth potential for the next recovery phase.

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