Growth for the Long Run:
Finding Capital Appreciation Potential
in a Low Return World
Janus Capital Group
By Jonathan Coleman, Brian Demain, Nick Thompson
September 21, 2012
Growth for the Long Run
“I skate to where the puck is going, not where it’s been.” – Wayne Gretzky
Many investors would love to be as successful as The Great One when it comes to their portfolios. Yet investors are often heavily influenced by the past, losing sight of where they need to be going. This seems to be especially true today: mistrust of equities is running high after a decade of disappointing returns and excessive volatility. Investors of all kinds are grappling with how to bridge the gap between their current assets and the increasing present value of their future spending needs and liabilities.
However, according to industry flow data, most investors have been reducing their exposure to stocks and increasing allocations to fixed income and absolute return strategies—asset classes not typically known for high levels of capital appreciation.
Given our long-standing belief that successful investing is predicated on thinking independently to help uncover opportunities that others may overlook, we offer the following “alternative” approach for investors challenged by today’s underfunding conundrum and asset allocation paradigm. Simply put, we believe that even cautious investors should refocus on their equity allocation and consider a prudent approach to gaining capital appreciation. One such way that we advocate is through a portfolio of durable, long duration growth equities—companies that have the potential to compound value for a long period of time—as a means to reach investors’ return objectives and help close the funding gap between their assets and liabilities.
These are some of the most challenging—and also opportune—investment conditions we have seen in Janus’ 40-years of equity investing. We hope that you find our insight and perspective both thought provoking and helpful.
Bridging the Funding GapÂ
It’s a simple conundrum: future funding needs are growing, while assets designed to meet those needs have not kept pace. For many investors, this is a significant problem that has only grown more severe as equity market performance has been disappointing in the last decade, generating returns well below the historical average. History shows that asset classes tend to recover following long stretches of weak performance, generating returns closer to (or above) their historical average. Yet instead of increasing exposure to equities—traditionally the best source of capital growth—investors have reduced their equity allocations and boosted exposures to fixed income and alternatives (see Exhibit 1).
Although these moves may reduce aggregate portfolio volatility, the returns will likely fall short of the growth needed to meet long-term obligations and future spending needs. Investors looking backward might not agree as fixed income has been on a bull run since the early 1980s. However, this experience is a historical outlier. As rates have declined, bond returns have been greater than historic norms while excess returns in equities have been the lowest since the 1930s (See Exhibits 2 and 3). With fixed income yields near record lows, however, it is unlikely that bonds will continue to exhibit such strong performance, increasing the importance of long-term capital appreciation from an equity allocation. Investors who thus allocate assets based on the trends of the last decade, in our view, are unlikely to reach their long-term goals.
Growth Equities: The Elephant in the RoomÂ
Demand for “risk-free” assets has soared as investors have pulled money out of stocks seeking the “protection” of U.S. Treasuries or other bonds perceived to be safe havens. A significant decline in equity valuations has been the result. Several forces appear to have driven this trend: investor unwillingness to pay as much of a premium for future growth given lower expectations in the wake of the Great Recession and credit crunch; a high degree of global macro uncertainty; and, unknown austerity measures likely to be implemented in the future.
Whatever the cause, the result of this de-rating of equities is that starting valuations for growth stocks-an important driver of future returns—look attractive. Historically, growth stocks have had higher Price-to-Earnings Ratios (P/Es) than the broader market, reflecting higher earnings expectations and systematic risk associated with growth companies. However, P/Es for growth stocks have declined in recent years, along with spreads between growth stocks and the broader market (See Exhibit 4). These trends likely reflect lower expectations for growth. But they also provide a more attractive risk/reward profile, in our view. Investors can now buy growth for less of a premium, even as the fundamentals of many companies have improved: balance sheets are generally stronger, companies have higher cash balances and returns on equity have risen in aggregate from levels before the Great Recession (see Exhibit 5).
Another important consideration is that, while correlations between equities have come down from their highs, they remain above average, as macro fears have continued to impact markets. This excessively high period of correlations is abnormal from a historical perspective, as Exhibit 6 suggests, and it is unlikely to persist. It has also resulted in attractive valuations for the best positioned companies as stocks have largely moved in unison. In short, investors may not be thinking about long-term capital appreciation with equities, despite evidence that the risk/reward profiles and fundamentals of many growth companies have improved.
Granted, the pressures weighing on multiples are significant. The global economy is slowing and corporate profit margins are near record highs—indicating less potential for expansion from here. Moreover, many companies have grown earnings through cost cutting and labor productivity gains, while revenue growth stagnated. These earnings drivers may be less powerful going forward, making it more difficult for companies to grow free cash flows. For well-positioned companies in attractive industries, however, we think earnings and margin expansion can continue. Given that an investment is worth the net present value of its future cash flows, equities that have the potential to grow those cash flows through the economic cycle should be a compelling investment compared to alternatives that have no potential to grow their cash flow (such as fixed income). The key, we believe, is to identify companies that have durable, long-duration growth drivers and the ability to grow in a slower growth world.
Identifying Durable Growth: Why Qualitative Factors Matter
An opportunistic, research-based approach is prudent given that durable growth companies don’t always reside in only one area of the market. While quantitative factors such as high returns on invested capital and rising free cash flow can be a good starting point for analysis, we believe qualitative attributes ultimately determine if a company’s growth will be sustainable for the long term. Companies with competitive advantages and unique, differentiated business models, for example, can not only survive but tend to thrive when confronted with tough macro conditions. We find the most attractive of these companies have pricing power and growing end markets. And in many cases, they operate in an attractive industry—i.e. one with few competitors, low customer concentration and high barriers to entry. Other important elements include a corporate culture that promotes employee buy-in and innovation; an advantage over competitors that is well protected and leads to pricing power; and an attractive risk/reward profile—where the stock isn’t trading at a significant premium to the value of its business. There is often less risk of fundamental missteps when companies have these attributes and a more attractive risk/reward profile in the stock. While not all inclusive, these elements most often form the foundation for durable growth.
The major indices may include a number of these stocks, but active managers can identify and overweight these companies in a portfolio, creating the potential for improved relative performance. Indeed, empirical evidence suggests that managers who differ significantly from the benchmark—for example, stock pickers with a high “active share”—are more likely to outperform than “index huggers”.
Durable Growth Equities: A More Cautious Solution for Long-Term Returns
Investors who need to close the gap between their assets and future funding needs should consider increasing their equity allocation to durable growth stocks that can provide sustainable capital returns over a market cycle. We believe investing in companies with strong business models and long-term growth drivers can result in strong positive returns over time. Entry points for growth stocks look compelling in our view based on a number of valuation metrics, including relative price/earnings ratios and valuations compared to fixed income. Even if the global economy weakens, companies with strong business models and durable growth drivers are more likely to gain market share, improve their competitive positioning and compound growth for shareholders.
We believe an in-depth, fundamental stock picking approach that combines qualitative and quantitative analysis can identify such stocks. The key is to analyze the sustainability, duration and magnitude of growth; use valuation tools to ensure optimal risk/reward; and invest with conviction in the face of market volatility and uncertainty. While the short term is always unpredictable, adding these companies to a portfolio creates a greater likelihood of achieving strong long-term returns that can meet investors’ future funding needs. â–
Please consider the charges, risks, expenses and investment objectives carefully before investing. For a prospectus containing this and other information, please call Janus at 877.335.2687 or download the file from janus.com/info. Read it carefully before you invest or send money.
Past performance is no guarantee of future results.
The opinions are those of the authors as of August 2012 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.
In preparing this document, the author has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.
Mutual fund investing involves market risk. Investment return and fund share value will fluctuate and it is possible to lose money by investing.
Stock represents ownership interest in a company. Stock investments have the potential to deliver high returns. However, with that potential there are also some risks. The value of equity securities fluctuates in response to issuer, political, market, and economic developments. In the short term, equity prices can fluctuate dramatically in response to these developments which can also affect a single issuer, issuers within an industry or economic sector or geographic region, or the market as a whole. Their performance has historically been more volatile than other asset classes.
Bonds in a portfolio are typically intended to provide income and/or diversification. In general, the bond market is volatile. Bond prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Alternative investments include, but are not limited to, commodities related securities, real estate securities, and other securities less correlated to the market, and are subject to inherent risks that an individual investor would need to address.
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S&P 500® Index is a commonly recognized, market capitalization weighted index of 500 widely held equity securities, designed to measure broad U.S. equity performance. Russell 1000® Growth Index measures the performance of those Russell 1000® companies with higher price-to-book ratios and higher forecasted growth values. A Fund’s portfolio may differ significantly from the securities held in an index. An index is unmanaged and not available for direct investment; therefore its performance does not reflect the expenses associated with the active management of an actual portfolio.
Systematic risk is the risk inherent to the entire market or market segment. Correlation is a statistical measure of how two securities or groups of securities move in relation to each other.
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