At the end of 2021, most growth-focused funds were sitting at or close to all-time highs, but the start of 2022 saw a savage rotation away from growth towards value. The sell-off was precipitous, wiping out the gains that had been made post the COVID panic of March 2020. Some of the most favoured investment companies plunged to significant discounts and many investors appear to have become disillusioned. IPOs and new issuance have dried up, and not just in our part of the market. Will this situation persist, or could we see a dramatic recovery?
Within the UK listed investment companies market, Chrysalis Investments was one of the worst hit, probably because it had quite a significant exposure to growing but loss-making businesses. The managers realised that for many of the companies in the portfolio, it might be hard/impossible to raise additional finance until sentiment improved. Their focus switched from identifying new investments to ensuring that the existing ones were financed through to profitability.
The progress that Chrysalis has made on this front has been impressive. In its latest quarterly NAV announcement published on Monday 31 July, it said that 85% of its portfolio was either profitable or funded to anticipated profitability at end June 2023. Encouragingly, its NAV moved higher for a second successive quarter too. That has been driven by the growth of the underlying businesses as well as by recovering valuations of equivalent listed companies.
Edinburgh Worldwide is another growth-focused fund that saw its NAV and share price crumble over the course of 2022. Not only has it been hit by the adverse sentiment towards growth, but also by a seeming aversion towards smaller companies.
There are good reasons for this. For one, the rapid rise in interest rates is putting considerable pressure on companies and consumers alike. There have been genuine concerns about the possibility of stagflation (inflation coupled with a slowing economy). Many of Edinburgh Worldwide’s underlying companies are also caught by the dearth of funding opportunities needed to finance their growth.
You might have though that fears of company failures would be good news for those investors who also focus on quality. Good examples of these are BlackRock Throgmorton and the two Montanaro smaller companies. However, the figures suggest that a quality focus (buying stocks with strong balance sheets and defensible market positions, for example) has actually been detrimental to returns. It is hard to see the logic here, except that valuation multiples have been hit across the board and quality stocks were quite highly valued going into this.
On the topic of illogical situations, how about the fall from grace of JPMorgan Japanese, which yes focuses on growth and quality, but also is investing in a market where there have been no rate rises and inflation, while picking up, is well below Western levels.
Growth investing worked as a style for so long that there are not that many true value managers left. However, Redwheel – managers of Temple Bar – do fall into that category. Redwheel feels that the success of growth investing following the financial crisis in 2008 was largely a reflection of cheap money (low interest rates and government largesse). One counter to that cited by growth managers is that technological leaps create opportunities for growth stocks to outperform.
One important strand of Redwheel’s argument is that growth companies tend to underperform because investors tend to be over optimistic about their prospects.
However, if we think about the valuations of the vast majority of the companies in the growth-focused funds that I have been discussing, it would be hard to argue that there is much overexuberance. For that reason, I think that these growth-focused funds will recover more than they already have.
However, we need to think about what the catalyst for that might be. The obvious one would be falling interest rates – a reversal of the conditions that led to the fall. Both the UK and US central banks are keeping rates on hold currently. If this does, in fact, mark the peak, then the future of growth investing may look a bit rosier.
James Carthew is Head Of Investment Companies at QuotedData