Can Large Growth Stocks Continue Their Upward Climb?
After a strong finish in 2017 (gaining more than 30%)1, large-cap growth stocks continue to lead the broader market. In January 2018, large-cap growth stocks, as measured by the Russell 1000 Growth Index, returned close to 7%. Despite periodic bouts of market volatility, we believe this upward trajectory may continue, as investors reward structurally advantaged growth stocks with accelerated earnings growth.
To develop a better perspective, we spoke with Portfolio Manager, Justin Kelly, CFA, who also serves as the Chief Executive Officer and Chief Investment Officer at Winslow Capital Management. Winslow Capital specializes in managing growth equities for an impressive roster of institutional clients, employing a philosophy and process that date back to 1999.
Growth Catalysts Extend Beyond U.S. Tax Reform
By some estimates, the near-term benefits of U.S. corporate tax reform may not fully be factored into consensus earnings forecasts. With a rise in growth projections, some strategists model mid-teen earnings growth in 2018. According to FactSet, of the 68% of S&P 500 companies that reported fourth-quarter 2017 earnings, nearly 75% had positive earnings surprises, and the majority also had positive sales/revenue surprises. In aggregate, the number of companies reporting negative guidance was well below average. Strong results were led by multinational technology and health care firms, which may benefit even further from tax reform and repatriation.2
Figure 1 – Earnings Growth Continues to Dominate Equity Returns
Historical Three-Year EPS Growth: Russell 1000 Growth Index
Source: FactSet. Historical three-year earnings-per-share (EPS) growth of the Russell 1000 Growth Index on a quarterly basis from January 2014 to February 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Although positive earnings revisions may provide a nice tailwind for equity returns in coming quarters, Winslow Capital believes emphasis should be placed on companies with competitive advantages, free-cash-flow growth, and strong returns on invested capital. For example, U.S. retailers are expected to initially benefit from the declining corporate tax rates; however, given the secular challenges facing brick-and-mortar retailers, this benefit may too quickly be competed away. As such, Winslow Capital remains skeptical of these stocks and is more optimistic about higher-growth companies that will continue to benefit from synchronized global growth and strong fundamentals.
Rebounding Share Buybacks and Capital Spending?
Share buyback activity in 2017 was relatively soft. However, if history repeats itself from the U.S. government’s repatriation tax holiday in 2004, we may experience a meaningful uptick in share buybacks and EPS growth, as companies redeploy a sizable influx of overseas cash. Technology firms and other multinationals with significant foreign sourced revenue may benefit the most from this dynamic. According to Bank of America Merrill Lynch estimates, roughly half of the repatriated cash could be used for share repurchases.
Winslow Capital also continues to monitor the outlook for capital spending as another key growth driver. According to Chief Investment Officer (CIO) surveys, capital spending is expected to reach its highest levels in 14 years, benefitting information technology firms with far-reaching benefits across other industries as well.
Is Growth Still Cheap?
With valuations already full, price-to-earnings (P/E) multiple expansion from current levels is less probable. On a relative basis, however, high-quality growth stocks remain attractively valued, relative to traditional value stocks and “bond proxy” sectors, but also the broader-growth universe.
Figure 2 – Big Growth Companies Are Cheap, Relative to the Growth Universe
Big Growers’ Ratio of Forward P/E versus Growth Universe
Sources: Empirical Research Partners, National Bureau of Economic Research from 1976 through December 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 chart compares the Big Growers’ forward P/E with that of the broader growth universe. These companies trade at a premium because they are better businesses. This premium has narrowed in the last few years to near historical lows. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Winslow Capital stresses the importance of diversifying across different types of growth stocks with a valuation discipline. Although market volatility may persist as we make the transition from quantitative easing (QE) to quantitative tightening (QT), late-stage bull markets have historically been driven by earnings growth and positive sentiment. Winslow Capital believes companies with the ability to compound higher earnings growth will continue to be advantaged in this equity cycle, favoring growth equities.
1. Source: Morningstar, as of 1/31/18.
2. Source: FactSet’s Earnings Insight, 2/9/18.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
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Large-cap growth stocks are measured by the Russell 1000 Growth Index.
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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