Growth investors have been rewarded handsomely in recent years reversing some of the long-term outperformance of value over growth. While UK markets do not necessarily present the same big tech investment opportunities – which have been a dominant source of returns within the US – the domestic so-called quality growth names have performed admirably and are responsible for driving a 30% outperformance of growth over value in the past three years, as measured by the MSCI UK Growth and Value indices.
At this juncture, with bond yields on the rise and inflation concerns gaining traction, investors are questioning whether growth investing can continue to deliver such strong returns. We are confident that the outlook for growth investing remains attractive, providing the correct approach is applied.
Approaches to growth investing
There are a number of different approaches to growth investing. Our preferred is to focus on ‘genuine growth’ companies which are able to deliver high, market-beating earnings growth and are supported by quality fundamentals such as profitability, high margins, and strong balance sheets.
Crucially, these companies generate strong free cash flow which can be reinvested at high returns on invested capital. This creates a self-funding, sustainable growth profile, which compounded over many years can be a significant driver of superior long-term returns. Importantly, the ratio of market valuations to the level of earnings growth delivery are well balanced within this cohort.
There are two other mainstream approaches to growth investing. The first tends to focus on blue-chip, high quality but low growth companies where current valuation multiples appear stretched relative to the rates of growth being delivered. The second approach seeks earlier stage, speculative opportunities where the return potential is significant, albeit this comes alongside a higher risk of failure.
The focus on genuine growth can naturally draw investors further down the market capitalisation scale where higher rates of growth are more achievable. In addition, smaller, often younger companies are more exposed to recent growth trends such as emerging technologies than some of their larger counterparts.
Growth opportunities
There is a common misconception surrounding a perceived lack of investable technology opportunities in the UK. This holds true for investors restricted to the FTSE 100, with software companies accounting for less than 1% of the index. However, this belies the fact that there are a multitude of high-quality, IP rich companies further down the market cap scale.
The Aim market is a particularly rich source of technology companies, many of which are highly profitable and genuine market leaders in their given fields. Exposure to technology within UK markets must therefore be accessed through an active stock-picking rather than a passive, index tracking approach.
Technology also lies at the heart of the UK’s future growth ambitions. In his spring budget the chancellor, Rishi Sunak, said: “I want to make the UK the best place in the world for high growth, innovative companies,” demonstrating a clear commitment to the space.
Technology is not the only source of growth within UK markets. There are various other attractive structural trends that are represented by UK Plcs, which include companies exposed to the green environmental agenda or increased infrastructure spend.
As the pandemic abates and we emerge from the worst economic contraction in over 300 years, there will also be numerous opportunities for investors to benefit from cyclical growth opportunities, particularly in those sectors which were hardest hit by measures introduced to tackle the pandemic.
The well capitalised market leaders within these sectors will thrive upon reopening, benefiting from pent up demand and strengthened market positions, whilst competitors saddled with debt will be severely restricted in their growth plans.
The rise in M&A
Another dynamic which has been gaining momentum over the past few months is a rise in corporate activity. It is no surprise to see deep-pocketed overseas buyers circling high quality UK assets, which are trading at attractive valuations and offer an additional FX discount given the relatively depressed level of sterling compared to long term averages.
It is always a shame for UK markets to lose the best and brightest companies, however, if UK investors don’t value these assets accordingly overseas buyers no doubt will. Growth companies are particularly vulnerable to M&A given their credentials: attractive intellectual property, high margins, strong balance sheets and exposure to structural trends.
Shifts in 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 is indeed a premonition for the future. Nevertheless, against this backdrop it is as pertinent as ever to focus on genuine growth companies, which are able to deliver high, real rates of earnings growth (adjusted for inflation), command pricing power and are attractively valued. In contrast, the approach of investing in blue-chip companies which are trading on high market valuations and delivering low rates of nominal growth is particularly exposed to valuation compression in the current environment.
The outlook for genuine growth investing in UK equities is positive. This is supported by an improving economic backdrop bolstered by the successful vaccination rollout and avoidance of a damaging no-deal Brexit scenario. Fiscal spend and government policy to reweight the economy towards innovative, higher growth companies adds further support to the existing attractive structural growth trends in play.
The valuations of UK growth companies are yet to fully reflect this improving trajectory and coupled with continued strong underlying growth, present an attractive combination for the long-term investor.
Alex Game is co-manager of the Unicorn UK Growth fund
