Some investors may be worried that market valuations are too high or that rising interest rates or inflation will hit valuations and cause a rotation away from growth stocks into value stocks.
However not all growth stocks are as vulnerable to corrections according to some fund managers, who argue that in the long-run, quality growth companies will continue to deliver strong returns.
Alan Christensen, manager of the Sarofim Global Equity fund, argued that the strongest companies can outgrow any decline in valuations.
“That growth characteristic will prevail throughout the cycle,” he said. “We can't measure it on calendar years.
“It's really about taking a longer-term view, understanding that there will be short-term volatility, but over the long run if you're invested in the right businesses, they will have the ability to outgrow the overall market.”
Even if there is a decline in the overall stock market, he said that businesses with strong recurring revenues and margins will ultimately prevail.
“The simple fact is that if you have five years of 15% earnings growth – that can withstand a 50% decline in the price-to-earnings [P/E] multiple,” he explained.
“If you see the market pullback, but you still have the ability to grow – you have the ability to outperform, and that 15% growth in good times will treat you well as you come out on the other side.”
Christopher Rossbach, manager of the J. Stern & Co. World Stars Global Equity fund, pointed out that without any decline in valuations, a company that can grow its earnings by 15% each year doubles in value every five years.
He explained: “Those earnings are the ‘E’ in the P/E ratio, so if the share price does not move the P/E ratio halves. It means that a company that many think is expensive at 30x P/E is cheap at 15x in five years.”
He said that in the event of a 50% correction, 15% earnings growth is needed to preserve the value of capital over five years, but over 10 years, only 10% earnings growth is needed to do the same thing.
The table below shows how different levels of earnings growth affect the share price and P/E ratio over time.
Simple valuation/multiple example
Another reason why a P/E ratio might de-rate is due to inflation – ie: higher discount rates or weakener corporate margins, but Rossbach argued that quality companies often come out stronger during these periods.
He said: “Quality companies have the sustainable competitive positions to increase prices, the scale to absorb cost increases in their raw materials and labour, and the balance sheets to be able to get through the tough period in the middle like right now – when costs go up but there is a lag before prices can be raised.
“This is when other companies go bust and quality companies get stronger by taking market share or buying their competitors.
“If a company can grow its earnings at a significantly higher rate than inflation, it’s P/E multiple can de-rate like in the example above and investors can still generate attractive returns.”
Indeed, Rossbach is taking advantage of the recent decline in valuations to buy companies who have been hit by valuation declines.
He said: “Salesforce’s short-term price to earnings multiple looks high, but we think it has a long trajectory of growth and value creation ahead, and we were able to buy it in February this year 40% cheaper than a year before, because the shares declined while its earnings went up.”
Although this worked well, avoiding market timing and investing in companies that consistently grow their earnings is the best way to generate returns, according to Gavin Harvie, manager the £209m Heriot Global fund.
He highlighted a statement by widely known value investor Benjamin Graham who described an ‘intelligent investor’ as a “realist who sells to optimists and buys from pessimists”.
Harvie argued that the ‘intelligent investor’ seeks to bias the outcome of investing in their favour through many methods.
He said: “While Mr Market is reliable in his tempestuous sentiments, depending on timing them as a sustainable source of return is not.
“We are realists as we acknowledge that time and growth unlock the most powerful bias to returns of all, what Einstein called ‘the eighth wonder of the world’, compound interest.”
In his view, the best growth companies offer patient investors “tremendous compounding opportunities” through their ability “to literally create wealth” by consistently reinvesting their profits.
He noted how these types of companies typically reinvest their profits into research & development and capital expenditure, which eventually leads to higher profits from their inventions and innovations.
He used Lonza Group – a Swiss-founded multinational chemicals and biotechnology company – as an example.
“Lonza has announced an increase in reinvestment to more than 90% of profits to drive earnings growth of almost 20% over the next five years,” he said.
“The company can do this because of its innovations in manufacturing processes that produce large quantities of pharmaceutical ingredients to an extremely high regulatory standard while entering commercial relationships that can last decades.
“It does this regardless of the trajectory of interest rates because at its heart the company is a nimble, innovation-based organisation that is determined to prosper.”