Growth investors have been widely rewarded in recent years, reversing some of the long-term outperformance of value over growth. While UK markets don’t necessarily present the same great opportunities for investing in technology – which have been a dominant source of returns in the US – the national names in so-called quality growth have performed admirably and are responsible. 30% outperformance of growth over value. over the past three years, as measured by the MSCI UK Growth and Value Indices.
At this point, as bond yields rise and inflation fears gain ground, investors are wondering if growth-oriented investments can continue to deliver such strong returns. We are convinced that the growth investment outlook remains attractive, provided the right approach is applied.
Growth-oriented investing approaches
There are a number of different approaches to growth investing. Our preference is to focus on “real growth” companies that are capable of delivering high earnings growth above the market and which are supported by quality fundamentals such as profitability, high margins and strong balance sheets.
Importantly, these companies generate strong free cash flow that can be reinvested with a high return on invested capital. This creates a profile of self-funded and sustainable growth, which, combined over many years, can be an important driver of superior long-term returns. Importantly, the relationship between market valuations and the level of earnings growth is well balanced within this cohort.
There are two other common approaches to growth investing. The former tends to focus on blue chip, high quality but low growth companies where current valuation multiples appear stretched relative to the growth rates generated. The second approach looks for early stage speculative opportunities where the potential for return is significant, although with this comes a higher risk of failure.
The emphasis on real growth can naturally attract investors lower down the market capitalization scale, where higher growth rates are more achievable. In addition, small, often younger companies are more exposed to recent growth trends such as emerging technologies than some of their larger counterparts.
There is a common misconception regarding the perceived lack of investable technology opportunities in the UK. This is true for investors limited to the FTSE 100, with software companies making up less than 1% of the index. However, this belies the fact that there is a plethora of high-quality, IP-rich companies further down the market capitalization scale.
The Aim Market is a particularly rich source of technology companies, many of which are true market leaders in their respective fields. Exposure to the technology in UK markets should therefore be accessed through active stock selection rather than a passive index tracking approach.
Technology is also at the heart of the UK’s future growth ambitions. In his spring budget, Chancellor Rishi Sunak said: “I want to make the UK the best place in the world for high growth, innovative businesses”, demonstrating a clear commitment to space.
Technology is not the only source of growth in UK markets. There are various other attractive structural trends which are represented by UK Plcs which include companies exposed to the green environmental agenda or increased infrastructure spending.
As the pandemic abates and we emerge from the worst economic contraction in over 300 years, investors will also have plenty of opportunities to take advantage of cyclical growth opportunities, especially in sectors that have been hit hardest by the measures taken to combat the pandemic.
Well-capitalized market leaders within these sectors will thrive on reopening, benefiting from pent-up demand and strengthened market positions, while indebted competitors will be severely constrained in their growth plans.
The rise of mergers and acquisitions
Another dynamic that has accelerated in recent months is the rise in business activity. It’s not surprising to see deep-pocketed foreign buyers circling high-quality UK assets, which are trading at attractive valuations and offering an additional discount on currencies given the relatively depressed level of the British Pound against long-term averages.
It is always a shame that UK markets lose the best and brightest companies, however, if UK investors do not value these assets accordingly, overseas buyers undoubtedly will. Growth companies are particularly vulnerable to mergers and acquisitions given their credentials: attractive intellectual property, high margins, strong balance sheets and exposure to structural trends.
Evolution of bond yields
The elephant in the room when it comes to growth investing is inflation and rising bond yields. Global markets are currently digesting the prospect of inflation, although it remains to be seen whether the recent shift in bond yields is transitory or in fact a premonition for the future. Nevertheless, in this context, it is more relevant than ever to focus on real growth companies, able to generate high real growth rates of profits (adjusted for inflation), to control prices and to be valued. attractively. In contrast, the approach of investing in blue chip companies that trade at high market valuations and offer low nominal growth rates is particularly vulnerable to valuation compression in the current environment.
The outlook for a real growth investment in UK equities is positive. This is supported by an improving economic environment, reinforced by the successful roll-out of vaccination and by the avoidance of a no-deal damaging Brexit scenario. Fiscal spending and government policy to reweight the economy towards higher growth innovative firms add further support to existing attractive structural growth trends.
Valuations of UK growth companies do not yet fully reflect this improving trajectory and, together with strong and continued underlying growth, present an attractive combination for the long-term investor.
Alex Game is co-manager of the Unicorn UK Growth fund