Two shades of growth for an uncertain market

Mark Baribeau February 28, 2023 11:43

Today’s markets are among the most challenging we have seen in several decades, and the lack of visibility, contradictory indicators, and macroeconomic pressures have investors on edge. Global equities declined into a bear market in 2022, with growth stocks among the worst performers. In the coming year, we believe the Federal Reserve will ease, and potentially end, its tightening cycle as the economy slows, and in this environment, we believe companies with reliable growth and exposure to secular themes have a long-term advantage.

Recognizing the key differences among these growth companies is helpful to better understand their behavior in different market cycles. In our experience, they can be divided into two broad groups, which we call emerging growers and stable growth compounders. Both groups have compelling long-term return potential, but they also have distinct risk and return profiles.

Emerging growers are young disruptors, in a new or developing industry, and offer significant upside potential. They reinvest their cash flow into sales, marketing, research, product development, and achieving scale, while reporting relatively low—or no—profits. Stable growth compounders, on the other hand, also offer upside potential, but they have a history of profitability and established drivers of growth.

They are often former emerging growers that have matured into large companies. They can maintain their competitive position through continued innovation and expansion into new markets or by leveraging an established business that cannot be easily replicated by competitors.

Both emerging growers and stable growth compounders have outperformed the MSCI ACWI for most of the past two decades.* The groups’ performance, however, has diverged at several points, especially over the last few years. Both benefited from the surge in technology adoption during pandemic-related shutdowns, but emerging growers were much more exposed to the Fed’s tightening cycle and rising interest rates. The selloff has lowered valuations for growth companies, offering potential opportunities because many of them continue to deliver steady growth.

Finding these opportunities is however extremely difficult. Most companies fail to live up to consensus growth expectations; in fact, consensus earnings growth forecasts have typically been either too optimistic or too pessimistic.

Another potential boost to performance comes from secular growth themes, which can provide significant tailwinds to well-managed companies. Over the next several years, we see several potential themes in areas such as emerging markets fintech, electric vehicles, luxury, and healthcare.

Businesses, organizations, and individuals throughout emerging markets are seeking more convenient and affordable financial services, offering a significant fintech opportunity in emerging markets. China was a powerful example of this trend, and we believe the potential for cashless payments, credit expansion, and digital banking services is enormous in other Asian and Latin American emerging markets. Investors, however, should be aware of idiosyncratic risks, including each country’s regulatory environment. Sudden, unexpected changes to regulations can negate long-term company plans, undermine competitive advantages, and make it virtually impossible for investors to model earnings and revenue growth.

Growth companies that offer differentiated products and services that create real value for society will continue to prosper.

After decades of development and promise, electric vehicles have captured the public imagination, forced strategic pivots from global auto companies, and laid the foundation for a full self-driving future. We believe the leading electric-vehicle players will redefine the relationship between carmakers and consumers, transforming the auto industry. The opportunity is also not limited to vehicles—the disruption includes batteries, the battery supply chain, and alternative sources of electricity generation.

In the luxury segment, many top brands have seen strong demand despite rising economic uncertainty. They continue to benefit from their positioning with consumers and the power of their operational and financial models. Moreover, demand for luxury goods has diversified. Today’s luxury consumers are younger—millennials and Gen Z account for a majority of purchases—and more American men have come to appreciate luxury and the top brands, which has helped drive growth.

In healthcare, companies are improving their ability to diagnose, monitor, and treat diseases with personalized therapeutics. We believe the current wave of innovation—especially for select companies with access to patient data—is on a trajectory similar to that seen in the information technology sector from 2010 to 2020.

The markets in 2023 will likely remain highly uncertain, but we maintain a long-term perspective. Growth companies that offer differentiated products and services that create real value for society will continue to prosper. We believe investors who understand the differences among growth companies, rely on bottom-up, fundamental investment approaches, and have exposure to secular growth themes are more likely to find opportunities. This is challenging, but history demonstrates that it is achievable and, above all, rewarding.

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Mark Baribeau

Head of Global Equities, Jennison Associates, PGIM