Growth stocks have been the apple of investors’ eye for years. Technology, software and e-commerce companies have grown imperturbably into leading billion-dollar corporations. In the wake of established names, the potential unicorns of the future sprang from the ground and eagerly took advantage of the opportunistic sentiment among investors to obtain fresh growth capital through a stock exchange listing.
After years of dominance by growth stocks, a plot twist in the financial markets, triggered by soaring inflation and tightening monetary policy, has caused an upheaval that even established growth companies have not been immune to.
Apple is perhaps the epitome of the growth stock success story. Through the Apple 1 computer developed in 1976 and the 1998 iMac that really put Apple on the map, the company successfully expanded its product range in the years that followed with groundbreaking innovations such as the iPod, iPhone, the MacBook, iPad and the Apple Watch.
Apple outperformed Russel 1000 4x in last decade
In 2018, Apple became the first publicly traded company to be worth 1,000 billion dollars. Two years later, the 2,000 billion dollars hurdle was taken and in less than 16 months following, the 3,000 billion dollars barrier was broken. Investors who have held Apple shares in their portfolios over the past ten years have been rewarded with a princely 1206 percent return measured in euros, four times higher than the Russell 1000 index.
The seemingly unstoppable growth of these stock market darlings, driven by an extra impulse during the coronal shockdowns, led to sky-high expectations and ditto valuations. Even loss-making companies with little or no proven track record were traded on stratospheric valuation multiples by euphoric investors. A new reality in which rising star managers achieved world fame.
Cathie Wood, the founder and manager of ARK Invest, personifies this. The success of the ARK Innovation ETF, which invests in technology companies active in artificial intelligence, blockchain, DNA sequencing, energy storage and robotics, was high-profile with a return of 156 percent by 2020. Until a plot twist in the financial markets brought about an almost equally spectacular downturn.
Gravitational pull of reality
Rampant inflation, which proved less temporary than central bankers initially suspected, forced monetary policymakers in the fourth quarter of 2021 to work out a plan to cut off the massive stimulus infusion. As interest rates rise and money is no longer free, investors find that the valuations of the most speculative technology stocks do not escape the gravitational pull of reality either.
The deterioration in sentiment among US growth stocks was somewhat masked by the outstanding performance of some of the heavyweights in the Russell 1000 Growth Index. Led by Apple, Microsoft, Tesla, Alphabet and NVIDIA, the index finished 2021 just 1 percent below its peak over the previous 52 weeks. However, 55 percent of the stocks in the index finished 10 percent or more below their annual top, 34 percent finished 20 percent or more below their annual top and 22 percent of the index names remained more than 30 percent off their annual top as at 31 December.
In the first month and a half of 2022, it is mainly loss-making technology companies that have lost out to investors. Rising interest rates lead to a higher discount rate for future cash flows. Sensitivity to interest rate increases increases the further in the future the cash flows, which pulls down the valuations of these companies. Mega-caps such as FAANG stocks could be less sensitive to this because they already generate huge cash flows, usually have a solid balance sheet with often a net cash position, strong pricing power and impressive profits.
Nevertheless, companies such as Meta and Netflix have also been punished harshly recently after publishing their annual results and outlining forecasts that investors did not like.
Baillie Gifford carries the red flag
For this top five, we look at the funds within the Morningstar US large-cap growth equity category, ranking them according to which funds have been hardest hit by the change in sentiment in financial markets since the start of the year.
Red flag bearer is Baillie Gifford Worldwide US Equity Growth Fund, which has lost almost a quarter of its value since the start of the year. The Scottish long-term growth equity specialist is experiencing significant outflows, exacerbated by the fall in the share prices of companies in which it has larger stakes, such as Moderna, Illumina and Zoom Video Communications.
The US Equity Growth Fund did not escape the malaise either. The largest position in the fund, a 9.3 percent allocation to Shopify, was hurt by a 35 percent fall in the share price. Moderna, number four with a 5.6 percent weighting, fell 40 percent and Affirm lost more than half of its market value. The fund, which posted a return of 110 percent in 2020, already had a difficult year in 2021, when a positive return of 5 percent was disappointing compared to the category average of 30 percent, and the loss in 2022 means that its long-term track record has lost its shine.
Two Morningstar Analyst Rating of Silver-rated funds from Morgan Stanley boutique Counterpoint Global, led by Dennis Lynch, are also in dire straits after an excellent 2020. Morgan Stanley US Advantage has a strong growth focus, but invests mainly in established growth companies, while the Growth variant is more adventurous and focuses more on potentially disruptive companies. Here too, there are large losses for stocks such as Roblox, DoorDash and Twilio.
Despite the bleak headwinds, Lynch remains firmly confident in the names in his portfolio. He argues that fundamentally the portfolio is in the best shape it has ever been in and believes that the companies in the portfolio have enough pricing power to pass on inflation to end-customers. During previous periods of rising interest rates, the strategy has also performed relatively well. No major changes to the portfolio composition are therefore to be expected, in line with the long-term horizon adopted by Lynch and his team.
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