Capital Ideas

Investment insights from Capital Group

Categories
Global Equities
Quality Growth: Resilient businesses in a low-rate world
David Polak
Investment Director
Steven Sperry
Investment Product Manager
KEY TAKEAWAYS
  • Growth stocks have continued to outpace value stocks in the recent market volatility.
  • Quality Growth, a subset of the growth universe, has shown relative resilience in this selloff. 
  • Experienced managements, robust balance sheets, high return on capital and strong cash flows characterize Quality Growth companies.
  • Quality Growth companies have shown stronger potential amid the global economic slowdown.

Growth stocks have continued to outpace value in the market decline and subsequent recovery following the COVID-19 demand shock. 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 GDP 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 Great 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, get redefined over the next few years as economies seek paths 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 demographics and technological advances.
 

Key ingredients of Quality Growth


As the economic environment has become more challenged, 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 what we’re referring to, the following exhibit summarizes some key aspects that we believe define Quality, Growth and Quality Growth companies. 

 

This diagram shows some of the characteristics associated with Quality, Quality Growth and Growth companies. For Quality, some of these are: shareholder focus often reflected in high dividends; highly profitable but not necessarily growing; and typically thrives in weak markets. For Quality Growth, some of these are: strong management teams; strong balance sheet; operating in a growing market; and potential to increase market share and maintain pricing power. For Growth, some of these are: typically pays minimal dividends; high growth rate but not necessarily profitable; and typically thrives in bull markets. Source: Capital Group.

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 remain attractive in most market conditions, often gaining share even in periods of economic slowdowns as consumers and enterprises shift behavior. 


At the same time, subscription-based businesses often address large total addressable markets (TAMs) that are global in nature, and this enhances their potential for compounding growth rates in stronger economic conditions.

  • An emerging participant is ServiceNow, which creates workflow management software that helps enable efficiency. ServiceNow has seen a rise in the use of their services by the customer service functions of many corporations, as its software can handle and sort phone, chat and email inquiries.

  • Microsoft is another business that has benefited from sticky subscriptions through its Windows Operating System, suite of Office products and its cloud service, Azure. Collectively, these features help create a more durable business model.

  • Another area beyond subscription-based business models is the luxury goods sector. Some of these companies, such as LVMH and Hermès, have been beneficiaries of increasing global wealth and consumer demand for aspirational brands. Global consumer spending trends have also benefited more traditional companies such as multinational food and beverage giant Nestlé

  • Another example is online payments, where significant and durable shifts in how consumers and merchants transact business are fueling growth. PayPal has been one of 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. The chart below 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.


This chart shows the five worst declines for the MSCI ACWI Index since 2007 and the number of days it took the index to recover from the market trough until a full 100% recovery. In this chart, the MSCI ACWI Index is compared with the MSCI ACWI Quality Index. During the Great Financial Crisis from November 1, 2007 to March 9, 2009, the MSCI ACWI Index declined 58.4% and took 1,529 days to recover; the MSCI ACWI Quality Index declined 50.0% and took 778 days to recover. During the European Debt Crisis from July 8, 2011 to October 4, 2011, the MSCI ACWI Index declined 21.2% and took 346 days to recover; the MSCI ACWI Quality Index declined 15.8% and took 123 days to recover. During the China Hard Landing from May 22, 2015 to February 11, 2016, the MSCI ACWI Index declined 19.2% and took 329 days to recover; the MSCI ACWI Quality Index declined 13.1% and took 176 days to recover. During the U.S./China Trade War, the MSCI ACWI Index declined 19.3% and took 304 days to recover; the MSCI ACWI Quality Index declined 18.0% and took 97 days to recover. During COVID-19 from February 13, 2020 to March 23, 2020, the MSCI ACWI Index declined 33.7% and MSCI ACWI Quality Index declined 30.2%. As of 7/21/20, MSCI ACWI had not reached a full recovery from the 2020 market decline. MSCI ACWI Quality recovered in 113 days. Sources: Morningstar, MSCI.

There are certain investment products in the marketplace based off the MSCI ACWI Quality Index. However, it is our view that the most attractive long-term Quality Growth stocks are identifiable, but only from a detailed understanding of each company’s fundamentals. A deep grasp of a company’s business model helps our investment team consider whether a company is merely riding the coattails of the economy or has a genuine ability to grow revenues from sustainable sources.


 


Anecdotes from past market corrections


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. Hence, the cause of the downturn is an important consideration, and some quality growth companies may fare better than others in some downturns. Here are some anecdotes from the last five market corrections to help illustrate that point.


 


Great Financial Crisis (11/1/07–3/9/09)

  • A real estate bubble burst, which had many spillover effects into both Main Street and Wall Street.

  • While consumers were retrenching and corporations were tightening their belts and de-leveraging, few companies were able to grow; but those that did were rewarded.

  • Novo Nordisk, the world’s leading producer of insulin, is one example. The company posted strong results in 2008 and subsequently upgraded its long-term forecast and increased their dividend in early 2009.

 


European Debt Crisis (7/8/2011–10/4/2011)

  • As many European countries struggled to pay their debt, some global cyclical companies sold off, especially the banks.

  • Quality Growth and dividend-paying companies held up well, including European-based semiconductor equipment maker ASML, which was helped by its global footprint and dominant position in a growing industry that allowed investors to look past the short-term weakness in the cyclical downturn.

 


China’s hard landing (5/22/2015–2/11/2016)

  • As fears rose about the global impacts of a slowing Chinese economy, companies that were heavily exposed to China, particularly commodity producers, led the market lower.
  • While much of the world was slowing down, the powerful tailwinds from a shift to online and mobile platforms allowed companies like Alphabet to continue growing. Many of its businesses saw limited or no impact from China’s slowdown, including Google Search, Google Maps, YouTube, and Android.

 


U.S./China Trade War (1/27/2018–12/25/2018)

  • Trade tensions and rising interest rates resulted in investors pricing in slower GDP and earnings growth.

  • Select companies that investors believed could maintain their earnings growth outlook held up well, including Danish utility company Ørsted.

  • How does a utility company have enough growth potential for us to highlight it here? Ørsted has been an industry leader in a rapidly growing renewable energy market: offshore wind.

 


COVID-19 (2/13/2020–3/23/2020) 

  • The spread of COVID-19 spurred unprecedented actions around the world that brought entire industries to a virtual standstill and led to a sharp selloff in equities, with cyclical companies and those with vulnerable supply chains seeing sharp declines.

  • Many companies operating digital businesses saw surges in demand as individuals and companies adjusted to social distancing.

  • Amazon (e-commerce), Netflix (digital entertainment), and Tencent (gaming, social media, digital payments) held up well.

 


Capital Group’s approach to finding Quality Growth opportunities post-COVID


London-based portfolio manager Chris Thomsen recently noted that “in a growth-starved world, I expect the market to continue to pay up for growth. Interestingly, many of those companies today have net cash balance sheets and high free cash flow generation.”


And portfolio manager Jonathan Knowles in Singapore put it this way: “Debt, deflation, devaluation, disruption: my acronym for what is going on remains DDDD. We have been in a period of significant disruption: old economic models are being upended by the rise of a new set of companies. Several of the world’s largest market caps barely existed 20 years ago. Now, we are witnessing another disruption more than a decade after the global financial crisis, characterized by unprecedented money printing and rising levels of government debt. In this environment, companies with strong business models in industries with long-term growth potential will continue to command a premium over the broader market.”


Many Quality Growth franchises have proven to be resilient so far this year, and changes in how people work and spend their leisure time have created opportunities for companies that provide the tools and solutions for altered lifestyles. The following are some examples.


 


This table breaks down the growth opportunities arising in a world changed by COVID-19 and the potential beneficiaries. In Row 1: Potential beneficiaries of virtually unlimited screen entertainment are video streaming and gaming companies. In Row 2: Potential beneficiaries of working from home productivity created by cloud-hosted applications are cloud providers, software-as-a-system and facilitators of digital communication. In Row 3: Potential beneficiaries of buy and deliver everything are grocery delivery, prepared food delivery and e-commerce companies. In Row 4: Potential beneficiaries of a desire to diversify supply chains and reduce reliance on dense workforce are companies involved in automation. In Row 5: Potential beneficiaries of a digital transformation of corporate America are cloud companies, software firms and those that can afford to invest in their future. In Row 6: Potential beneficiaries of a focus on the importance of health care innovation are pharmaceutical and biotech firms.

So how is Capital Group positioned to identify these trends and differentiate between the companies that might benefit and those that may suffer setbacks in the post-COVID world?


Capital Group takes a hands-on approach to fundamental company research, leveraging a team of more than 300 analysts, portfolio managers and economists who have been at Capital for an average of 13 years (as of March 31, 2020). Last year they participated in more than 12,000 company meetings to gain deep insight into everything from macro and industry trends to company-specific trends across various regions. These meetings help our investment group calibrate both global and local trends. It is our view that our global footprint enables our group to have a view across global supply chains and company capital structures, helping them identify potential investment opportunities on both a bottom-up and top-down basis.



David Polak leads the investment specialist team representing Capital Group's global equity services. He has 35 years of industry experience and holds a bachelor's in economics from University College London.

Steven Sperry is an investment product manager with 10 years of industry experience. He holds a bachelor's degree in global business: financial management from Arizona State University. He also holds the Chartered Financial Analyst® designation.


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 captures large and mid-cap representation across 23 Developed Markets (DM) and 26 Emerging Markets (EM) countries. 

 

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 (DM) and 26 Emerging Markets (EM) 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.

RELATED INSIGHTS

Hear from the investment team.

Don't miss out

Get the Capital Ideas newsletter in your inbox each week

*REQUIRED

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the mutual fund prospectuses and summary prospectuses, which can be obtained from a financial professional, and should be read carefully before investing. Similar information about collective investment trusts can be obtained from Capital Group or participants' plan provider or employer.

All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.

Use of this website is intended for U.S. residents only.

American Funds Distributors, Inc., member FINRA.

This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.