Is It Time To Buy Growth Stocks Again?

After the sector’s losses last year, Polen Capital’s Rayna Lesser Hannaway says the job is now to separate the winners from the losers.

Illustration by II

Illustration by II

Investors aren’t ready to bet on growth stocks even after the market turbulence in 2022 punished the style.

Growth companies in the S&P 500 index lost an average of 29.4 percent last year, the worst performance of all factors, according to data from S&P Global. High-growth companies, which are those boosting revenue at more than 20 percent per year, were trading at a price-to-earnings ratio of 40 as of the end of December, the lowest level since 2014, according to data from $1.4 billion U.K.-based investment manager CDAM.

But as macroeconomic uncertainty keeps mounting, the distressed valuation in the growth sector may not be enough to bring investors back. Growth stocks need clearer outlooks on inflation, earnings prospects, and interest rate policies, among other things, to thrive.

Investors’ skepticism is reflected in the consistent outflow from growth funds in the past year. According to data from Morningstar Direct, net inflows into U.S. small- and mid-cap growth funds were negative every month last year. The case for large-cap growth funds isn’t much better, with March and June being the only two months that had positive inflows. In the fourth quarter alone, the net outflow from all types of U.S. growth funds reached a total of $34 billion, up from $23 billion in the third quarter and $27 billion in the quarter before.

“Some people will bottom fish in certain growth stocks, [but] the big picture of the macro landscape hasn’t changed enough to favor growth,” according to Ed Clissold, chief U.S. strategist at Ned Davis Research, a sister company of II. For growth stocks to become more attractive, inflation needs to be close to the 2 percent target set by the Federal Reserve, he said.

The debate over when growth will come back started after the end of the first quarter in 2022, according to Ed Rackham, co-chief investment officer at Los Angeles Capital Management. The company has developed a model that tracks investors’ preferences for different factors. At the time, growth stocks had slumped after rate hikes and rising geopolitical tensions between Russia and Ukraine, leading some investors to believe that they had become more attractively priced. But in the following months, persistent inflation and the mounting fear of a recession weakened the case for growth stocks and the prices didn’t look quite so good after all.

Rackham added that investors’ position on growth equities has shifted from overweight to neutral since the first quarter of last year. “They are looking for assets which have high quality, potentially durable cash flows, [and] are well priced,” he told II in an interview. But right now, many growth companies are facing headwinds that might undermine their ability to generate stable income. For this reason, investors, “are not necessarily prepared to overpay for growth.”

Even managers themselves are becoming more selective about their stock picks. There are not enough to go around. “You can only [invest in growth] with a concentrated portfolio now,” Rayna Lesser Hannaway, who oversees Polen Capital’s small-cap growth strategy, told II. “You need to separate the winners from the losers. I don’t think it makes sense in the current environment to buy small-cap blindly.”

According to Clissold, over the next two to five years, value stocks will be a better bet. Value beat growth by 24.2 percent last year, according to S&P Global. NDR’s own model now favors value over growth by one of its widest margins ever.

“If you look at things like valuations, earnings expectations, and the macroeconomic environment, those still favor value over growth,” Clissold said. For example, the one-year trailing earnings growth is -18 percent for large-cap growth stocks and 22 percent for their large-cap value peers.

“That doesn’t mean that you can’t get spectacular rallies on growth stocks for a few months,” he said. “But for the next few years, the environment should favor value over growth. This is a longer-term call.”