A year ago, we ventured into what many considered the perilous waters of the growth market, a realm perceived as tainted by speculators and retail investors pursuing glamorous stocks for rapid gains. Furthermore, we decided to dip our toes in the most prominent of these arenas — the US stock market.
In a blog post last year, we expressed our preliminary thoughts and disclosed findings from our rigorous research on this initiative we termed "smart growth." Managed via the Atlas platform — our forefront tool for portfolio customization — we translated this project into a tangible investment product.
Now, marking a year since the product's inception, we return to share reflections on our trajectory and to offer insights into the evolving market landscape in our ongoing blog series.
Navigating the Landscape of Growth Investing
There exists not a single path but a multitude of approaches to growth investing. Here, we concentrate on what we perceive to be a prudent strategy for managing growth portfolios.
As systematic investors, we place our trust in a rich bed of academic literature and data, complemented by our proprietary research. This dual reliance springs from navigating the increasingly complex territory known colloquially as the “growth zoo,” a sphere where various factors exhibit wildly varying degrees of risk and robustness. A cautious approach is not just recommended but essential, given the untamed nature of elements within this zoo of factors.
Certainly, one could argue that the most unrestrained strategy — often viewed as the prince of darkness in the gallery of investment styles — is simply buying the most expensive stocks on the market, a method antithetical to value investing. This unprofitable strategy, characterized by a relentless pursuit of glamour stocks, has historically been driven by high-growth stocks, at least in the past sense.
We advocate for a growth strategy predicated on anticipated future growth, raising the relevant question: how does one identify stocks with high expected growth?
Decoding Growth Investing Through a Refined Lens
As recent as 2021, scholars Kewei Hou, Haitao Mo, Chen Xue, and Lu Zhang pioneered the integration of a growth factor into an asset pricing model, unveiling their paper titled “An Augmented q-Factor Model with Expected Growth.” This seminal work introduces an “expected growth” dimension to the renowned q-factor model initially conceptualized in 2015, offering a fresh lens through which to anticipate a company’s future investment growth using proven predictors like profitability growth.
Without delving too deeply into the details, it stands that this innovation, which leverages a distinct approach to asset pricing compared to its predecessors, represents a substantial contribution to asset pricing discourse.
In shaping our investment strategy, we prioritize future investment growth, a component often linked with unexpected growth not yet fully accounted for in markets. This strategy, underscored by a strong presence of quality attributes, leverages not only the expected growth factor but also profitability, morphing into a quality growth (QG) strategy.
To fortify this approach, we incorporate other robust measures of growth momentum, including price momentum and earnings surprises, both of which have garnered support in research as reliable predictors of future investment growth. Further enhancing our predictive prowess is the monitoring of a company’s allocation to research and development (R&D), a noted harbinger of growth.
Guided by these meticulous growth parameters, we are confident in our ability to craft a sensible growth investment strategy, poised to outperform market returns over an extended horizon.
The State of the US Stock Market
A year ago, growth stocks plummeted amid surging inflation and hawkish central banks. The timing seemed inauspicious for a growth strategy launch. In 2022, value firms experienced their best year against growth stocks since 2000. Yet, our quality-biased approach showed resilience in late 2022, highlighting its defensive attributes against volatile growth strategies.
In 2023, performance reversed as growth stocks reclaimed market leadership. One catalyst for growth recovery was a technical one—some stocks had been unduly battered. Early 2023 witnessed an astonishing ascent of unprofitable growth stocks. During this period, our QG strategy lagged, except for the Big-7, comprising the seventh largest mega-caps.
The emergence of the US regional banking crisis in March and the subsequent turmoil weighed heavily on unprofitable stocks. The spring frenzy surrounding artificial intelligence (AI) and language learning models propelled technology stocks even higher. Our QG strategy, inherently invested in AI-related stocks like Alphabet, Microsoft, and later Nvidia, seamlessly integrated this growth theme due to their inherent quality.
Valuations and Outlook
Growth stocks inherently command higher valuations due to superior growth potential and higher quality. Yet, the valuation gap between US value and growth stocks has become extremely wide in historical terms. Bloomberg data illustrates this divide—the Russell 1000 Value index trades at a PE ratio of 17, while the Russell 1000 Growth index trades at 33, almost double.
The primary downside risk resides in unprofitable expensive companies. Disappointments in growth within such stocks often lead to significant price declines. Another potential challenge for growth firms is a looming wave of inflation. However, this is contingent on an economic slowdown or possible recession, which would quell inflation. Notably, large growth companies exhibited defensive traits recently, favoring growth over value in a recessionary scenario. Despite these insights, the uncertain economic outlook restrains definitive conclusions.
A Balanced Approach to Growth Investing
In crafting a QG investment strategy, the underlying rationale is clear: bolstering the diversification of a global equity portfolio. The client sought a large-cap growth strategy, a tool essential in broadening exposure to existing return drivers, including those grounded in value.
This represents the keystone of sophisticated investment — the harmonious coexistence of intelligent value and growth strategies. Given the typically low correlations of excess returns between value and growth stocks, the potential for substantial diversification benefits is considerable.
As the age-old adage suggests, forecasting is very difficult, especially if it’s about the future. While pinpointing the optimal style for your equity portfolio in the coming months or years remains elusive, an astute approach involves combining various styles, such as value and growth. The success of this method hinges on the thoughtful design of investment strategies.
Peter Lindahl
