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Quality Growth: Resilient businesses in a low-rate world
David Polak
Steven Sperry
August 26, 2020
KEY TAKEAWAYS
- Growth stocks have continued to outpace value stocks during recent market volatility
- Quality Growth, a subset of the growth universe, has shown relative resilience
- Experienced management, solid balance sheets and strong cash flows characterize Quality Growth companies
Growth stocks have continued to outpace value in the market decline and subsequent recovery following the COVID-19 outbreak. In our view, growth will continue to command a higher premium relative to other investment opportunities for two reasons:
- True growth investment opportunities are fewer in a world of low economic growth rates.
- An ultra-low interest rate environment reduces the discount rate to evaluate stocks. This allows investors to extend time frames, which tend to favor growth opportunities.
Since the 2008—2009 financial crisis, the premium placed on growth companies has been most pronounced in non-U.S. markets, but it has been a rising trend in the U.S. as well. That said, sources of economic growth are likely to change and, in some areas, be redefined over the next few years on the path to recovery. Capital Group’s fixed income specialists similarly see this era of low rates continuing for an extended period due to powerful deflationary forces such as technological advances and aging populations in developed countries.
Key ingredients of Quality Growth
As the economic environment has deteriorated, members of our investment team are finding that not all growth opportunities are on equal footing. Increasingly, many of our portfolio managers are focusing on a subset of growth companies that they view to be Quality Growth.
While there is no perfect screen or set of rules that can embody all aspects of Quality Growth, they are finding that these companies typically share the following ingredients:
- Led by strong management teams
- Maintain solid balance sheets
- Operate in a growing market
- Exhibit the potential to increase market share and maintain pricing power
Clearly, not all of these characteristics are exclusive to Quality Growth companies — strong balance sheets and high-quality, experienced management teams are traits that portfolio managers look for across all types of companies.
But when these traits are found in companies that also have attractive business models or are tapping into secular growth opportunities with a long runway, they can potentially make for attractive investment opportunities.
One example of a strong secular growth trend is subscription-based businesses. They have compounding characteristics that have been attractive in most market conditions, often gaining share even in periods of economic slowdowns as consumers and enterprises shift behavior.
An emerging participant is ServiceNow, which creates workflow management software that helps enable efficiency. ServiceNow has seen a rise in the use of its tools by the customer service functions of many corporations, as the software can handle and sort phone, chat and email inquiries.
A more familiar name is Microsoft. Its business has benefited from sticky subscriptions through the Windows Operating System, a ubiquitous suite of Office products and its Azure cloud service. Collectively, these features help create a durable business model.
Another example is online payments, where significant and durable shifts in how consumers and merchants transact business are fueling growth. PayPal has been among the market leaders.
Are these all-weather stocks?
An interesting aspect of many Quality Growth companies is that they have shown greater resilience and quicker recoveries versus the broader market. This chart shows the MSCI ACWI Quality Index as a proxy. The companies in this index are selected based on high return on equity, stable year-over-year earnings growth and low financial leverage.
While Quality Growth companies, as a group, have often held up relatively well during market downturns, it is important to remember that their ability to do so has been largely predicated on their ability to continue growing, even when many other companies cannot.
Therefore, the cause of the downturn is an important consideration, and some quality growth companies may fare better than others in some downturns. Moving forward, some potential beneficiaries in the aftermath of COVID-19 may be businesses that operate in areas of video streaming and gaming, grocery delivery, automation and biotech.
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Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility, as more fully described in the prospectus. These risks may be heightened in connection with investments in developing countries. Small-company stocks entail additional risks, and they can fluctuate in price more than larger company stocks.
The MSCI ACWI is a free float-adjusted market capitalization-weighted index that is designed to measure equity market results in the global developed and emerging markets, consisting of more than 40 developed and emerging market country indexes.
The MSCI ACWI Quality Index is based on the MSCI ACWI Index, its parent index, which includes large- and mid-cap stocks across 23 developed market and 26 emerging markets countries.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
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