Does quality growth investing still deliver?

Does quality growth investing still deliver?
Tim Richardson CFA, Investment Specialist

Global quality growth stocks underperformed during 2022. This was due to a perfect storm of excessive valuation levels, rapidly rising interest rates, and the very gradual pace of the economic slowdown. Australian investors can now gain exposure to high-growth trends via top-quality global businesses at attractive price levels.

“The investor of today does not profit from yesterday’s growth.”
– Warren Buffett

What is quality growth?

Growth companies are those expected to increase profits over a sustained period, driving earnings per share growth. Growth companies often exploit transformative technologies, valuable patents, or new markets.

Quality investing aims to identify resilient companies with characteristics which include:

  • Competitive advantage – unique product or strong brand
  • High-performing management team – effective strategy implementation
  • Astute corporate governance – independent board oversight
  • Earnings quality – from bankable profits rather than financial engineering
  • Strong balance sheet – appropriate debt levels

Quality growth investing integrates the two concepts, aiming to deliver sustainable profit growth with earnings resilience when economies slow.

So what happened in 2022?

Quality growth investors often outperform when economies weaken and profits fall – e.g. following the global financial crisis. Yet quality growth underperformed during 2022.

So is the investment style still relevant?

A slowing economy impacts quality growth companies in two distinct ways:

  1. Multiple compression – expectations of rising interest rates push up bond yields and thus equity discount rates, (share prices fall when discount rates rise). This tends to push down all stock prices but especially growth companies, whose earnings lie further out into the future.
  2. Margin retention – the profitability of quality companies is typically driven by a wider range of factors beyond just consumer spending; hence they can better maintain – or even grow – their earnings as the wider economy slows.

The impact of margin retention will generally outweigh that of multiple compression, helping quality growth stocks outperform when the economy slows. But this did not happen in 2022.

This was because the impact of multiple compression and margin retention usually takes effect more-or-less simultaneously; but didn’t this time.

Growth stocks had become extremely expensive during the pandemic bull-market, fuelled by near zero-interest rates. Share markets are sufficiently efficient that quality companies are seldom ‘cheap’. But following this sustained period of rapid earnings growth they had become valued at particularly expensive earnings multiples by the end of 2021. Therefore, quality growth companies’ share prices fell particularly steeply in early 2022 when interest rates began to normalise.

Simultaneously, the economy was surprisingly resilient last year, despite falling real incomes and rising mortgage payments. During two years of Covid lockdowns, incomes were largely protected, while discretionary spending (travel, socialising, etc.) fell steeply, boosting household savings. This ‘Covid cushion’ supported household spending last year as disposable incomes fell.

Hence quality companies did not enjoy their expected profitability advantage over more cyclical companies with lower quality earnings, whose profits held up surprisingly well.

These two factors meant quality growth stocks underperformed last year.

So what happens next?

The Covid cushion is now much diminished, having been drained by wages lagging inflation, and rising mortgage payments. The resulting downward adjustment in household spending is particularly impacting companies whose revenues and earnings are especially sensitive to changes in the level of consumer spending. There are now increasing signs that share prices are adjusting as investors differentiate between the earnings of cyclical and quality growth companies.

Meanwhile, many quality growth companies should be better positioned to maintain or even grow earnings. This has enabled attractively valued quality growth stocks to outperform the broader share market since the start of 2023. It may further outperform over this year if consumer spending continues to fall and interest rate expectations remain relatively stable. This would see the continuation of the longer-term outperformance of quality and growth stocks:

Quality and growth stocks outperform over the long-term

Source: Bloomberg and Pengana

Which companies will outperform in the next stage of the economic cycle?

Higher interest rates have slowed the global economy, bringing a wider dispersion in earnings. But companies with limited variable-rate debt, lower sensitivity to discretionary household spending, and a competitive advantage can still grow earnings.

These include:

  • Technology companies aligned with secular growth trends such as artificial intelligence
  • Life science groups able to develop and secure approvals for transformative drugs
  • Industrial automation groups which optimise manufacturing processes as production is onshored to high-cost markets
  • Strong brands with data-driven insights into direct relationships with loyal customers
  • Luxury goods houses exposed to global travel growth more than mass market spending patterns

What does this mean for investors?

Quality growth’s 2022 underperformance was unexpected, but due to unique circumstances which are unlikely to reoccur soon.

The current rebound in quality growth stocks reflects their faster earnings growth throughout the business cycle as interest rates approach their peak.

This is an opportune moment for investors to consider how different stocks will perform in the next phase of the economic cycle and review their exposure to quality growth stocks.

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Pengana Capital Group