As the mid-cap market shifts, we believe investors would be wise to focus on valuation-sensitive growth. Portfolio Managers Brian Demain and Cody Wheaton explain.

Key Takeaways

• During 2020, we began to warn of excesses building in the Russell Midcap Growth^® Index, as high-valuation stocks largely drove performance.
• In 2021, the market began to normalize as real interest rates stopped declining ‒ albeit at negative rates ‒ and reasonably valued stock performance improved dramatically.
• Low interest rates ‒ and the prospects that they will rise ‒ have affected both value and growth stock valuations. While value stocks have recently been outperforming growth, we believe investors would be wise to focus on valuation-sensitive growth as the mid-cap environment evolves.

During 2020, we began to warn of excesses building in the Russell Midcap Growth^® Index. For an extended period, a large portion of the Index was valued at levels requiring future growth that historically only a small portion of companies have been able to achieve. As an example of the speculative nature of some valuations, one can look at the chart below, showing the percentage of stocks with price-to-sales ratios greater than 20. These extremely expensive stocks spiked to over 25% of the Index in 2020 ‒ levels not seen since the tech bubble of 1999-2000.

Source: Janus Henderson Investors, Factset, as of 1/31/2022.

During this time, managers who emphasized reasonable valuations in their investment processes found headwinds in the strong performance of the most highly valued companies in the Index. Rather than smart growth ‒ focused on patience, consistency and the power of compound growth ‒ mid-cap performance relied largely on the momentum of exorbitantly priced stocks with unrealistic growth expectations.

During 2021, the market began to normalize as real interest rates stopped declining ‒ albeit at negative rates ‒ and reasonably valued mid-cap stock performance improved dramatically. Late in the year, the Index began to correct as the Federal Reserve (Fed) acknowledged that rising inflation needed to be addressed and indicated future withdrawal of monetary stimulus, raising expectations for higher interest rates in 2022. This correction accelerated into a bear market in the Russell Midcap Growth Index, as the decline from the top exceeded 20%. However, while valuation multiples within the Index have compressed, they remain elevated compared to historical norms. The question in the mid cap market continues to be, “what price are we willing to pay for growth?”

Growth at What Cost?

It is true that digital transformation has allowed companies to grow faster than they could in a pre-cloud, tangible economy in pursuit of large total addressable markets (TAMs). This has driven meaningful multiple expansion in the stock market, specifically for growth stocks. We have also been in a period of generally declining nominal interest rates for several decades. Low interest rates encourage higher valuations, and negative real interest rates ‒ such as we have recently experienced ‒ can be even more impactful, as investors are effectively being paid, in real terms, to borrow and invest for higher returns. The market is now trading with an extreme level of sensitivity to real rates, and if real rates remain negative, we believe it will remain sensitive to daily rate movements. On the other hand, if real rates rise, it could create a tailwind for more reasonably valued growth stocks.

On an individual company-level, one risk of investing in a low interest rate environment is that the penalty for being wrong in long-duration growth stocks is exceptionally high. The market is currently putting tremendous value on cash flows that are well out into the future. If those cash flows do not occur, because they are so highly valued, the penalties in the stocks will be high.

Thus, fluctuating costs of capital can affect high-growth companies, but they can also disrupt value companies. Generally speaking, value companies are more economically sensitive. In 2022, we expect there will be macroeconomic headwinds from rising rates, waning fiscal stimulus and elevated inflation. This makes it difficult fundamentally for value companies if the economy slows. Additionally, some businesses are being kept afloat by low rates and could face funding headwinds should rates rise. We would also argue disruption is real, and many traditional value sectors face structural headwinds and deserve their low multiples. While value has been recently outperforming growth, we believe investors should focus on valuation-sensitive growth ‒ companies with the potential for durable growth, but with more reasonable valuations.

Patience Is a Virtue

So, we see certain areas of risk in the mid-cap growth market, but also find numerous areas about which we are excited. These include solid, steadily growing companies that are being overlooked by the market, companies beginning to compound growth, those that are mispriced for the durability and predictability of their cash flows, businesses with upside optionality and companies with large TAMs that are still early in the disruption cycle. Ultimately, as the economy and the mid-cap market continue to evolve, we think that owning quality, compounding businesses at reasonable valuations can potentially be a successful strategy over a long period.