Dan Nickols, manager of the Old Mutual UK Smaller Companies Fund, and Richard Watts, manager of the Old Mutual UK Mid Cap Fund, outline their current preference for growth over value stocks.
It is an age-old conundrum for investors. Should value stocks – shares that typically trade at lower prices relative to underlying fundamentals and are therefore cheap – top the list of portfolio favourites? Or should growth stocks – those whose earnings are expected to grow at a superior rate relative to the underlying stock market – be given greater attention?
The argument for those who favour the value route is well trodden. Rising inflation and gradually increasing interest rates typically bode well for value strategies. Investors will have started to notice pockets of inflation bubbling up already in the system. This has broadly favoured economically cyclical stocks such as engineers, industrial and miners – stocks which have been rerated in anticipation of a pick-up in the reflation trade.
But if the heightened tensions over world trade start to act as clouds on the economic growth horizon, than those same economically sensitive stocks may start to look fully valued. Fortunately, in our wider investment universe, growth opportunities abound. Our central case – that growth stocks, with the ability to positively surprise on the profits front, can continue to offer investors better long-term potential than value stocks – remains intact.
The chart below plots the performance of value versus growth stocks in the UK All Companies universe and the UK mid and small cap world. The light green line, which includes FTSE 100 companies, shows how value has outperformed growth stocks, the reverse is true when we strip out the FTSE100 component and looks solely at mid and small cap stocks. Our conclusion would be that the strength of the growth opportunity among UK medium and small-sized companies currently outweighs the value opportunities.
The presence of the growth dynamic is further evidenced by the latest corporate earnings season for mid and small cap stocks, showing profit ‘beats’ exceeding ‘misses’ by a wide margin. The misses were largely confined to those companies with underlying structural challenges, for example much of the bricks-and-mortar, conventional retail sector which is struggling in the face of disruptive online competition.
In the current environment, we believe the focus of attention should be on the three ‘ds’ of investing – stocks with dynamic earnings growth, disruptive technology, and/
or distinctive brands. Fever-Tree Drinks is a classic example of a company that has literally shaken up the mixers market with its premium brand offerings. While the company has made great strides in the UK, the real kicker of future profits growth is the company’s US expansion plans. We believe growth in this potentially vast market is the key to future multiple expansion.
Blue Prism, the developer of robotic software, is a clear technology disruptor. Although currently loss making as it invests in sales and marketing, the group has an attractive recurring revenue profile which, coupled with its ability to expand market share, bodes well for future profits growth.
Indivior is another stock in the mid-cap space that, we believe, has significant growth potential. The US Food and Drug Administration recently gave its approval to Sublocade, the group’s first monthly injectable treatment designed to combat opioid addiction. Given the worldwide problem of heroin addiction, the success of this new product should equate eventually, we believe, to US$2billion of net revenue for the company. Company management has confirmed this to be a billion-dollar drug, meaning the current price/earnings multiple looks way too low in our view.
It should be clear from the above stock examples that we are not struggling to find new growth opportunities in the mid and small-cap universe. We continue to believe that the earnings potential from both the mid and small-cap space remains superior to that of FTSE 100 companies.
So, to the question we posed at the beginning of this article. As investors, do we, in the current environment, want to participate in the value theme and buy cheap stocks, waiting for them to ‘mean revert’ back to an average price because they may be looking marginally unloved? Or, do we believe there is greater merit in finding stock specific ideas that have the potential to deliver sustained, positive earnings surprise by virtue of a business model underpinned by a unique product or service? This is a question we are continually asking ourselves. Our view is that this is an environment where genuine growth can continue to command a premium valuation – as ever, the key is to ensure that our forward-looking company analysis is of a quality that enables us to identify those opportunities where share prices don’t already discount the growth on offer.