Seeking Growth in a Changing World by Staying Active

Written by: Steve Sciortino

Year-to-date through the middle of September, U.S. growth stocks have posted outstanding results, with the Russell 1000 Growth Index gaining approximately 16%. In contrast, the Russell 1000 Value and S&P 500 Indices have returned close to 6% and 11%, respectively. To gain some insights on the current environment, and to better understand the opportunities and risks in the market, we recently spoke with Justin Kelly, CEO and CIO at Winslow Capital Management (“Winslow”) and Portfolio Manager for Mainstay Large Cap Growth Fund since 1999.

Large cap growth stocks leading in performance year-to-date

Source: Morningstar, as of 9/20/18. Past performance is not indicative of future results. It is not possible to invest directly in an index. Index definitions found at the end of this blog post.

The tax reform tailwind

One of the drivers of this year’s exceptional returns for large-cap growth stocks is tied to the benefits from tax reform. The most obvious benefit is the lower corporate tax rate. Less obvious is the huge Capex cycle that it has triggered. Case in point, the CEO of a leading global bank explained that the company is spending a lot of the benefits from tax reform on technological enhancements. This, in turn, has boosted the growth for a number of technology companies which, in some cases also saw their business fundamentals improve at the same time that their tax rates declined.

Valuations: More than meets the eye

Given the performance of large-cap growth companies, it’s reasonable to ask whether valuations have become expensive. The short answer is yes. And no. To be sure, some large-cap growth stocks are now expensive. But at the same time, other companies in the space offer attractive valuations. To get a better handle on this, consider the three ways Winslow classifies growth companies: dynamic growth, consistent growth and cyclical growth. Two years ago, dynamic growth companies were extremely cheap from a historical perspective. Today, many have become expensive. In contrast, consistent growth companies—those firms that can grow through various economic conditions—offer attractive relative valuations. Elsewhere, investor sentiment for certain cyclical growth companies has become challenged due to concerns over global tradewars and moderating growth overseas. Actively rotating among the three types of growth companies can be a prudent way to access the upside of the large-cap growth market, while paring a portfolio’s exposure to companies with unattractive valuations. This is an advantage active managers have relative to indexed strategies.

Types of growth stocks

Dynamic GrowthConsistent GrowthCyclical GrowthCompanies in dynamic positions with superior competitive advantages generating revenue growth at/or above 10%Companies with earnings-per-share (EPS) growth greater than the market and demonstrated acyclicalityCompanies exposed to product, industry, regulatory or economic cyclicality with prospects for superior earnings growth in the forward 24 months

Targeting the growth companies of tomorrow

A key theme we see playing out in the years to come is the journey companies are taking (or not taking) to transition from the analog world to the digital world. In our view, this is creating bigger winners and losers than at any point in history. That’s because the change mechanism to digital is happening at a much faster rate than, for example, the industrial revolution. There are obvious winners, such as certain companies in the technology space. There are also large companies outside the technology arena using data in the digital world to gain competitive advantages against smaller companies.In contrast, a number of large multi-national consumer goods companies are on the wrong side of the digital transition and have lost their competitive advantages. In the past, many of these companies had a distribution advantage with physical stores. Today, they continue to lose market share to online retailers. And brand advertisingthat was previously so successful has become antiquated, as user reviews carry more weight with consumers. This leads to opportunities to invest in companies that we refer to as “staple replacements.” Many of these businesses are not owned by traditional large-cap growth managers, but they offer high quality franchises that are replacements for consumer staples. One such example: a payment company that should continue to reap the benefits as consumers increasingly utilize “digital wallets.”

The active advantages

Actively managed large-cap growth portfolios were challenged during the quantitative easing (“QE”) period. Over that period, investors favored higher dividend-paying stocks, as they offered attractive dividend yields in a low interest rate environment. Fast forward to today, it’s apparent that many of those companies have poor business models and weakening fundamentals. Not surprisingly, the percentage of active managers outperforming their benchmarks has risen.Going forward, we believe active managers with the resources to conduct extensive research and micro economic analytics will be advantaged given the increase in return dispersion in the marketplace. In addition, we feel identifying companies with superior growth trends that have pricing power to deliver sustainable earnings growth will be increasingly important in the year to come.

Since the Federal Reserve began paring quantitative easing and raising interest rates, active large growth managers have outperformed, driven by security selection and sector allocation.

Source: Morningstar, as of 6/30/18. Active Large Growth managers defined as 232 non-Indexed Funds/non-ETF institutional funds with a 3-year tracking error > 4.0%. Peer performance is net of fees. Past performance is not indicative of future results. It is not possible to invest in an index. Alpha measures a fund’s risk-adjusted performance and is expressed as an annualized percentage. Index definitions can be found at the end of this blog post.