Whether or not inflation is transitory is perhaps the most central debate amongst investors today. Growth stocks – which have outperformed over the past decade – are seen as the most vulnerable if inflation rises or central banks raise interest rates to combat it.
However, not all growth stocks will be as equally hurt, according to Matthias Born, manager of the FE fundinfo five-crown rated £1.3bn Berenberg European Focus fund.
When the market adapts to a new regime of higher interest rates or higher inflation, Born said it could initially lead to some relative underperformance of growth investing for a period.
But longer term, the manager does not see a big risk “because any impact from the valuation side is then usually overcompensated by the underlying growth rates these firms have over a two-to-three-year horizon,” he explained.
“So therefore if you have companies that are growing 15% to 20% – even a 20% to 25% hit to valuation multiples could be overcompensated on a three-year time horizon quite easily.”
He said the companies that won’t be hit as hard are those that have delivered stable growth over the long term and cannot be attacked by competition.
Born added that the most important determining factor is the ability of the companies to grow profitably with positive cash flows, as these companies are more resistant to higher interest rate or inflation environments.
He said: “If you look since beginning of the year, what has performed in the growth space and what has not – you will realise that the non-profitable part of the growth space had a difficult period this year.”
The reason for this was because non-profitable companies performed exceptionally well in 2020, but also because these firms have their profits further out in the future and are therefore hit harder by rising interest rates or inflation, he noted.
The manager admitted there was no doubt that rising interest rates or rising inflation would hit the performance of all growth stocks, but how much it hit them depended on the type of growth – which can be cut into three distinct types: defensive growth, cyclical growth and high growth.
Defensive-growth stocks are companies with barriers to entry, lower growth rates, and higher profitability. Born said one example is Danish pharmaceutical company Novo Nordisk.
Share price performance of Novo Nordisk year-to-date
Source: Google Finance
“Lower growth names like Novo Nordisk have high profitability, but they're at the lower end of growth rates at 10% growth – maybe a bit higher if they execute well over the next few years,” he said.
“In this space even if you have a hit on valuation or increase in interest rates – it is seen as very defensive, and these are often seen as more of a bond proxy.”
However, even in the defensive growth camp, he said investors need to picks stocks that are truly growing. If the company is not able to grow at 10% and instead is growing at 5%, the overcompensation for potential losses in valuation does not really work, according to the manager.
Cyclical-growth stocks are companies with higher growth, but tend to move with the market cycle, such as Dutch semiconductor equipment supplier ASML and luxury goods business LVMH.
“We call them quality cyclicals,” Born said. “It depends on the economic outlook: if interest rates are increasing because the economy is improving then I don't have any concerns about being positioned there.”
However, if interest rates rise due to inflation and it chokes off economic growth, they won’t be so well off.
Finally, high-growth stocks are companies with higher growth rates of 25% to 30%, but often have limited profitability.
This is the part of the growth investment universe which would be hit the hardest in terms of valuation, according to Born.
“Therefore it's so important to pick the profitable ones like Hellofresh, for example,” he said.
One example of this is in the valuations and performance of companies in the European food delivery space.
Share price performance of Hellofresh year-to-date
Source: Google Finance
“Hellofresh is quite profitable already,” Born said. “On the other side, you have the delivery firms like Deliveroo or Just Eat, where the performance has been worse.
“I think investors have been favouring the most profitable firm in that space overall, which is Hellofresh.”
Hellofresh is up 25% year-to-date, whereas Just Eat Takeaway is down 35% year-to-date and Deliveroo which is down 26% since its IPO, dubbed one of the worst in London’s history.