Expensive US growth stocks need not suffer from reflation and rising interest rates. On the contrary, they will thrive thanks to their pricing power, says Ton Wijsman, senior portfolio manager at AllianceBernstein and former director at W.P. Stewart.
Lots of first-time retail investors entering the stock market, a lot of speculation around smaller companies such as GameStop and hefty valuations. All signs point to extremely positive equity market sentiment. Wall Street in particular looks expensive, with an expected P/E of 22.5 for the S&P 500. Only in the late 1990s this multiple was higher.
But according to Ton Wijsman, there is no bubble. ‘Before the burst of the Internet bubble in 2000, shares such as Cisco were quoted at more than 200 times earnings, while Microsoft’s P/E was around 50. Now there is another group of tech companies such as Zoom, DocuSign and Shopify that have seen valuations rise sharply,’, he says.
These high-flyers make no or very limited profits yet, but attract attention mainly because of their spectacular revenue growth. This is what attracts investors, says Wijsman. Of the six largest companies in the S&P 500, he finds only Tesla and Amazon very highly valued. ‘The price/earnings ratios of Microsoft, Facebook, Apple and Alphabet are actually not too bad,’ he says. ‘With a 12-month froward P/E-ratio of around 30, Microsoft may not be undervalued, but the company is growing fast, is the market leader and has little to fear from competitors for the time being. We believe that the valuation in relation to the growth prospects is still very much justified.’
Focus on high growth
With a weighting of 9.8%, Microsoft is the largest position in the WP Stewart Holdings Fund. WP Stewart Asset Management was acquired by AllianceBernstein at the end of 2013. At that time the AB Concentrated US Equity fund was also introduced, which has the same portfolio as the WP Stewart Holdings Fund. Alliance Bernstein decided to keep the WP Stewart name for marketing purposes.
The funds invest in a select group of high-quality US growth companies that are able to achieve sustainable earnings growth of at least 10% per annum. ‘Relatively few companies are able to sustain this rate of growth for long. In the period 1979-2020, only 21 of the 1000 largest American companies managed to achieve an annual profit increase of 10% during five-year periods’, says Wijsman.
Since WP Stewart was founded in 1975, the holdings in the portfolio have, in the vast majority of years, posted average earnings growth of between 10 and 25% per year. ‘On average, profit growth has been 14.5% per year. Our search for these kinds of strong growers leads to a narrow universe of 40 to 50 stocks. We follow them with six analysts. We then include the 20 most attractive stocks in the portfolio,’ says Wijsman.
A common characteristic of these companies is that they sell unique products with relatively little competition. ‘They are located in market segments with structural growth and are therefore less dependent on the macro environment.’
Pricing power
In addition to Microsoft, Wijsman mentions global healthcare company Abbott Laboratories, car parts maker Aptiv and Mastercard as examples. ‘The latter has been in the portfolio for 12 years and shows profit growth every year, even during the financial crisis in 2008/2009. There are only a few large credit card companies worldwide and there is still a lot of growth in this market. Payment cards still only account for 25-30% of the world’s payment transactions and market penetration can still increase significantly in a cashless society.’
Growth stocks have the wind in their sails thanks to low interest rates and may well lag the market once interest rates start to rise. ‘Higher interest rates normally mean lower price/earnings ratios,’ admits Wijsman. ‘However, much depends on the pace at which interest rates rise. If interest rates rise gradually because of an improving economy, our portfolio will not do worse than the market. Our companies also have relatively little debt on their balance sheets, so higher interest rates will not depress profits. Moreover, earnings growth is continuing, which means that price/earnings ratios are falling,’ he adds.
Wijsman thinks the portfolio’s current forward price/earnings ratio of about 28 is reasonable and also not far above the historical average of roughly 25. ‘With expected earnings growth of 12-14% a year over the next five years, the price/earnings ratio will drop to just 15 at constant prices. We therefore expect a good performance based on a three- to five-year investment horizon.’
Thanks to their ‘unique market position’ these companies also have strong pricing power, Wijsman notes. ‘Even if inflation goes up, they can increase prices and protect their profit margins. So compared to the wider market, these companies are relatively inflation-proof. Therefore they should still be able to realise outperformance in an inflationary environment.’