Large Cap Growth’s Resurgence Driven by Stronger Fundamentals
Large cap growth stocks, as measured by the Russell 1000 Growth Index, have performed exceptionally well in 2017, returning just over 17% through the end of July. The change, as expected by some, is being driven by quality firms with sustainable business models. How did we get here? To develop a better perspective, we spoke with Justin Kelly, CFA, CIO and Portfolio Manager, and Barry Peters, CIMA, Managing Director of Marketing and Client Service at Winslow Capital Management. Winslow Capital specializes in managing growth stocks for an impressive roster of institutional clients with a philosophy and process that dates back to 1999.
Stock Prices Have Reconnected with Earnings Growth
With the unwind of quantitative easing (QE), interest rates on a global basis have started to move towards a path of normalization. This, in turn, has led to a change in market leadership, as investors once again reward companies with strong fundamentals and accelerated earnings growth. In the current environment, in which growth is scarce, Winslow Capital expects quality growth stocks to outperform other areas of the stock market over the next several years.
So far in 2017, stock returns have been driven by robust earnings growth. During the second quarter, close to 65% of companies within the S&P 500 Index reported positive earnings results that beat Street consensus estimates. In aggregate, S&P 500 companies experienced double-digit earnings-per-share (EPS) growth. Higher growth stocks, to include the information technology sector, are especially compelling, based on secular trends, positive earnings revisions, and attractive relative valuations.
Figure 1 – With Strong Earnings Growth Potential, Technology Stocks Have Room to Run
Technology-Forward EPS and P/E Spread vs. S&P 500 Index (3/6/09 – 6/30/17)
Source: Bloomberg LP and Market Realist. Past performance is no guarantee of future results.
In 2016, style pure, active growth managers struggled to keep pace with dividend-yield headwinds from non-traditional growth stocks with little-to-no earnings growth, and in many cases, stretched valuations. Winslow Capital viewed these stock price dislocations as an unprecedented opportunity to capture growth at an attractive price. Although the U.S. stock market has performed exceptionally well year-to-date, large capitalization “big growers” remain inexpensive, relative to both growth and value stocks.
Figure 2 – Growth Stock Valuations are Near 40-Year Lows!
Growth is Cheap, Relative to Value…
And Growth is Cheap, Relative to Growth.
Source: Empirical Research Partners, National Bureau of Economic Research from 1976 through June 2017. “Big Growers” are the 80 or so stocks with the best growth characteristics based on factors such as the level and consistency of their growth rates, ability to self-fund that growth and also valuation. The charts compare the Big Growers’ forward P/E with that of the broader value and growth universes. These companies trade at a premium because they are better businesses. This premium has narrowed in the last few years to nearly 40-year lows. Past performance is no guarantee of future results.
Not All Growth Stocks are Created Equal
Winslow Capital believes quality growth stocks represent a structurally-advantaged asset class. These companies are less dependent on market multiple expansion and have the ability to generate sustainable, free-cash flow capable of financing internal growth. While the outlook remains positive, not all growth stocks are created equal. As shown in the chart below, during the QE era, investors favored low growth stocks. The lowest growing stocks within the Russell 1000 Growth Index have nearly doubled their PEG ratio, or the P/E (Price/Earnings) multiple paid per unit growth. With the end of QE and a resurgence in market fundamentals, active stock selection under the new equity market regime is important.
Figure 3 – QE-Era Propelled Investors into Low-Growth Stocks
Russell 1000 Growth Index in 3 Growth Tranches
Source: Winslow Capital Management, FactSet, as of 6/30/17. The Price-to-Earnings to Growth (PEG) ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company’s expected growth. The inception date of the Russell 1000® Growth Index is January 1, 1987. Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. An investment can’t be made in an index. The study ranks the Russell 1000 Growth Universe (approx. 600 stocks) on a monthly basis by consensus average growth rate of current and next year. FY2/FY1 and FY1/FYO (50% each) using FactSet consensus estimates. Each month, the list is then sorted by that consensus average growth and broken into three equal groups approximately 200 each. The Low growth represents the bottom third of the universe growth rates and the high growth is the top third. The chart depicts the PEG Ratio (ratio of consensus Fwd P/E from FactSet divided by the consensus average growth rate.) for each of the “portfolios”. The portfolios are market cap weighted. The chart highlights that the PEG ratio, or the P/E being paid per unit growth, has doubled over this period, while the growth universe is valued roughly the same per unit growth since the start of QE – Quantitative Easing. The PEG ratio is used to determine a stock’s value while taking the company’s earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. While a low P/E ratio may make a stock look like a good buy, factoring in the company’s growth rate to get the stock’s PEG ratio can tell a different story.
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“Big Growers” are the 80 or so stocks with the best growth characteristics based on factors such as the level and consistency of their growth rates, ability to self-fund that growth and also valuation.
Earnings-per-share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.
Free cash flow is the amount of cash a company is able to generate after making required investments in the existing business, such as for new machinery and to pay for supplies.
Large cap (sometimes “big cap”) refers to a company with a market capitalization value of more than $5 billion. Large cap is a shortened version of the term “large market capitalization.” Market capitalization is calculated by multiplying the number of a company’s shares outstanding by its stock price per share. The dollar amounts used for the classifications “large cap,” mid cap” or “small cap” are only approximations that change over time.
The Price-to-Earnings to Growth (PEG) ratio is a valuation metric for determining the relative trade-off between the price of a stock, the earnings generated per share (EPS), and the company’s expected growth.
P/E Ratio (price‐to‐earnings) denotes the weighted average of all the P/Es of the securities in the fund’s portfolio.
Russell 1000 Growth Index refers to a composite that includes large and mid-cap companies located in the United States that also exhibit a growth probability. Russell 1000 Growth Index refers to a composite that includes large and mid-cap companies located in the United States that also exhibit a value probability. Both are subsets of the Russell 1000 Index.
The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. Index results assume the reinvestment of all capital gain and dividend distributions. An investment cannot be made directly into an index.
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