As markets normalize, Portfolio Manager Jonathan Coleman sees the potential for high return-on-invested-capital (ROIC) companies to once again be recognized by the market.

Key Takeaways

• Last year saw volatility in small-cap growth stocks, and we continue to see rapid leadership changes in the asset class as investors weigh the effects of the pandemic alongside shifting monetary and fiscal policies.
• In recent years, performance within the small-cap growth index has become dominated by what we believe to be risky stocks: stocks that are often unprofitable, with higher valuations and in higher-risk industries.
• That said, as we move toward the endemic phase of COVID-19 and a more normal environment, we believe we can see the market once again reward companies deploying capital at a high rate of return ‒ more in line with historical trends.

Small-cap growth stocks ‒ and equity markets in general ‒ have been volatile as investors weigh the potential path of COVID-19 alongside the likelihood for more persistent inflation and the impending slowdown of pandemic-related stimulus. Within the asset class, we continue to see a market leadership struggle between high-growth, high-valuation investments ‒ many of which were COVID beneficiaries with virtual business models ‒ and more stable growth companies with ties to the physical economy. While this back-and-forth dynamic is likely to continue, we are encouraged by signs we may be returning to an environment in which investors reward profitable companies with high returns on invested capital.

Benchmark Risk and the Effects of Higher Rates

In recent years, performance within the small-cap growth index has become dominated by what we believe to be risky stocks: stocks that are often unprofitable, with higher valuations and in higher-risk industries. While each market environment is unique, this development is not unlike what we saw in previous periods of speculation like the dot-com bubble of the late 1990s and early 2000s.

While high-growth stocks have outperformed at times, many of these stocks were shaken as the Federal Reserve (Fed) has acknowledged that the acceleration in inflation readings needs to be addressed and decided to speed the withdrawal of monetary stimulus, raising expectations for higher interest rates in 2022. During the last couple of years, the Fed has undertaken extreme monetary measures that are now starting to be reduced.  We believe the prospect of these actions has brought a measure of rationality to the market and could begin to favor more sustainable business models. Understandably, as expected discount rates have begun to rise, investors have reassessed the valuations for some of the hyper-momentum and high-multiple stocks that have driven small-cap growth equity benchmark performance over the last couple of years. Indeed, upward changes to interest rates (and thus discount rates) that are already near historic lows can have a significant effect on the present value of cash flows far out in the future, which can be particularly impactful for high-growth company valuations.

We have certainly approached these high-multiple stocks with caution, especially where we see a disconnect between company valuation and underlying profitability. We think this disciplined approach may help insulate investors from some of the downward volatility in the small-cap growth market.

Focus on Smart Growth as the Market Normalizes

We recognize that the tug-of-war between high-growth pandemic beneficiaries and “real-world” physical economy stocks is likely to continue in coming quarters as investors await more clarity on the path of the pandemic, the timing of Fed interest rate moves and other issues. We also recognize that the above-average market returns of the past few years may be hard to replicate in 2022. Rates remain low from a historic standpoint, but they will likely move higher as the Fed withdraws its policy support. Companies are also navigating supply chain bottlenecks and labor shortages, leading to inflation pressures.  We believe that these pressures may be more persistent than many investors have previously appreciated, causing the Fed to engage in more interest rates hikes than are currently expected.  Higher interest rates (than we have lived with in the recent past) enforce rationality in capital allocation across the economy and are ultimately healthy for sustainable expansions, rather than purely speculative ones.

In the face of these worries, we believe investors would be well-served to seek out disciplined, well-managed and reasonably valued growth companies with track records of innovation and profitability. Further, companies with established supplier relationships and strong competitive positioning may be able to pass along higher input costs without sacrificing profit margins. We believe these types of “smart growth” companies may be better able to navigate near-term market fluctuations and eventually capitalize on long-term trends as we return to a more normal market environment.

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