“Water, water everywhere, nor any drop to drink.” -The Rime of the Ancient Mariner, Samuel Taylor Coleridge.
How can growth be both abundant and scarce at the same time? For investors, the answer may yield a fresh way of looking at growth stocks.
Like water, growth appears to be everywhere—at least on a global scale. Countries representing 96% of the world’s gross domestic product are generating growth, according to the International Monetary Fund. But if growth is happening almost everywhere, why are growth stocks doing so well? After all, in economics, the scarcity of something—not the abundance—should be the variable that drives up its price.
The answer may lie in the caliber of growth that is happening within that 96%. Only 40% of the world’s GDP is experiencing above-average levels of growth.
While growth is abundant, it’s still lackluster. This dynamic can help explain why growth stocks have appeared to be so pricey. Investors have been paying up for stocks—not only in terms of companies from which analysts have been expecting high long-term earnings per share (EPS) growth—but mostly for those companies for which analysts have been revising up their expectations for growth.
The following chart highlights the return differential between companies in the Russell 3000 Index that have been simply growing, and companies that have been accelerating their growth. As you’ll see, companies with accelerated growth have stock prices that have been commanding a premium.
Can growth create value?
Simply looking at valuation measures might suggest that growth stocks are pricey, but there’s something else at play. When growth is scarce, it tends to command a premium price. Growth is abundant in the sense that profits and economies are growing, but in a world of below-average growth, companies that have delivered accelerating growth have tended to be rewarded by the markets. Here’s an excerpt of a recent podcast interview with Mike Smith, portfolio manager with the Fundamental Growth Equity Team:
“…when growth is scarce, that scarcity creates value. This is the weakest economic expansion, going back to World War II—the expansion that began in 2008, average GDP growth of 2.2%, head and shoulders, the weakest. So if you think about it, at a high level, there’s not a lot of growth to be found anywhere, when you look around the economy. The companies that we invest in have a unique attribute that should be worth a lot. And yet, up until very recently, there was really no premium implied in their valuation. We think we’re at the beginning phases of a lot of value being created by that scarcity.”
The multi-asset viewpoint
From my perspective on the Multi-Asset Solutions Team, I prefer value over the long-term, but in a world where there’s a paradox of abundant but scarce growth, growth can continue to command a premium. In addition, this paradox can help provide context for portfolio allocations. I believe it supports the idea of considering keeping a growth allocation in line with its strategic weighting in a portfolio, despite high valuations.
This paradox also helps in terms of thinking about whether to take a more active or passive approach to a particular area of the market. Instead of thinking of the active-passive allocation as applying wholly to the portfolio, I think of it as applying to particular segments of a portfolio at particular points in time. Broadly, active management can add more value in those asset categories where good information is harder to come by. That’s where the active research component can add value.
Lastly, the paradox of abundant but scarce growth also applies at different times to different parts of the market. U.S. markets are very competitive where there is an abundance of information, but good insights about which companies will be able to defend their competitive position, grow their market share—or as Mike Smith would say, be on the right side of change—can be very valuable when valuations are stretched.
Dr. Brian Jacobsen, CFA, CFP, is a Senior Investment Strategist with the Wells Fargo Asset Management Multi-Asset Solutions Team.