Style is not eternal

• For now, growth stocks, ESG stocks and positive-impact stocks are out of fashion
• On a price-to-sales basis, ‘emerging growth’ stocks are trading below their long-term average
• Innovative growth companies that can solve meaningful problems tend to create significant value for their shareholders over time

Only one style is always in fashion

Believe last year’s narrative and the financial world is all about ESG investing these days. Yet just a matter of weeks into 2022 and that notion can be firmly put to bed: energy stocks are leading the market, followed closely by financials. Poor old growth stocks, which until recently were flavour of the month, are painfully unfashionable. Even defensives are coming under pressure. After years in the doldrums, meanwhile, value is enjoying the top spot.

Clearly, the majority of investors are interested in a particular style of investing. But that style is not buying growth, ESG stocks or positive-impact stocks. Although the rise of passive investing and style-factor ETFs has helped to reduce holding periods and increased volatility, the popular investing style today remains the same as it has always been: whatever happens to be working at any given moment…

Our style, however, doesn’t change. We believe in the ability – and necessity – for innovation to solve the many impact problems that exist today. So we invest in emerging-growth stocks focused on the future. Over the first few weeks of this year, this has not been a fun part of the market to be in. As my colleague Craig Bonthron recently explained, babies have been thrown out with the bathwater. But our style isn’t changing.

What caused this shift?

We all have a view of what caused this change in style, whether it be interest rates or inflation – and how those dynamics will play out. So I will spare you another opinion on those subjects.

What I would say is this: don’t underestimate the impact the pandemic had on the real world and on financial markets. The disruption it caused has been greater than any of us imagined. It brought forward the adoption of new technologies and, in the stockmarket, widened valuation differentials to levels not seen before.

We invest in ‘emerging growth’ stocks. These companies are growing quickly, are (re)investing in their own future growth and are too young to be regarded as ‘established growth’ stocks. During the pandemic, valuations of these stocks rose to levels not seen in the period since the financial crisis. Was that sustainable? My hope was that inflation would remain at manageable levels, that the path back to interest rate ‘normality’ would be a gradual one and that the rapid growth of the type of companies we invest in would allow their valuations to normalise without a large drawdown.

Clearly, however, that has not been the case.

Emerging growth stocks are no longer ‘expensive’

I don’t know when the underperformance of emerging growth as an investment style will end; nobody does. I don’t have a crystal ball and I can’t tell you what the next month, three months or even 12 months will bring in terms of our companies’ share-price performance. But what I can say with confidence is that this group of stocks is no longer expensive.

‘Emerging growth’ stocks now trade on price-to-sales multiples that are below their long-run average¹. Returns (blue line, LHS) are shown on a log scale (starting from 100%). Price-to-sales multiples (bronze line, RHS) are shown on a forward basis for the current financial year.

We monitor a short list of 300 ‘emerging growth’ stocks. In share-price terms, the average stock on this list is now 55% below its 12-month high. The good news is that, after a painful few weeks, valuations of these stocks on a price-to-sales basis are now below their 12-year average.

Moreover, these 300 stocks include a number of what I firmly believe will prove to be the most important companies in the world. Whether they are developing new energy systems, revolutionising the way we diagnose and treat illness or changing the way we educate ourselves, some of these businesses will allow humanity to leave the unsustainable path it is following today.

One sidenote… While ‘emerging growth’ stocks now trade on price-to-sales multiples below their 12-year average, the same cannot be said of what we call ‘established growth’ stocks. In particular, mega-cap technology stocks have, until recently, remained largely impervious to the recent growth sell off. And, because valuations here remain elevated relative to their long-term average, it is possible there is more downside to come from the stocks in this style bucket.

Shares of ‘established growth’ stocks still look expensive on a price-to-sales basis relative to their long-term average Returns (blue line, LHS) are shown on a log scale (starting from 100%). Price-to-sales multiples (bronze line, RHS) are shown on a forward basis for the current financial year.

Companies that solve meaningful problems also tend to create meaningful shareholder value

By continuing to focus our capital on companies innovating to improve the world that we live in, we will help them on their journey. Past experience suggests that these emerging growth businesses will generate huge value for their shareholders given time. We intend to capture a chunk of that value for our clients.

So, as a team, we continue to focus our time on finding, buying and holding companies that are helping to solve the many environmental and social issues that confront the world. Those challenges are no less pressing than they were six weeks ago – and they matter far more than temporary matters of style.

¹We build and monitor four ‘style’ buckets: ‘established growth’, ‘emerging growth’, ‘defensives’ and ‘cyclicals’.  Each bucket contains 50 equally weighted stocks that we believe best reflect the relevant style. We use quantitative and qualitative factors to pick those stocks. We refresh these buckets once a year and only change their constituents when compelled to (in the event a company is bought out or delists). We are happy to share the stocks that constitute these style buckets on request.