“Hope and hype” replacing fundamentals?

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March 2022

Walter Scott client investment manager George Dent argues that while the growth sell-off might appear indiscriminate, it pays to look beyond the noise for quality companies.

Rising inflation, higher interest rates and escalating global political tension have driven a shift away from growth, but not all such stocks should be tarred with the same brush, says Walter Scott client investment manager George Dent.

Dent says the recent sell-off in growth stocks may appear indiscriminate, but it is important to distinguish between “quality growth” and other companies to which a broad growth label is often applied.

“For some companies, growth can be fleeting, reflective of business models that are not durable, rely on too much debt, or that have weak competitive moats with products or services that are insufficiently differentiated,” he says.

According to Dent, some companies may be benefiting from the recent economic recovery, but their profitability could come under pressure against a backdrop of surging costs and the prospect of rising interest rates.

He says: “In some cases low interest rates have led to irrational exuberance where hope and hype have, to varying degrees, replaced fundamentals as an investment metric, with hefty valuations applied to companies with distant prospects of idea monetization and profitability.

“A reset in monetary policy will remind investors of the importance of the cost of capital and sustainable profit growth.”

Dent thinks the recent appetite for value stocks “speaks of investor interest in cheapness and laggards.” Using banks as an example, he notes that while some of these companies are “having their day in the sun” few of them have ever met Walter Scott’s investment criteria on the basis they employ “massive leverage and are financially and operationally opaque.”

Dent says Walter Scott defines ‘quality growth’ companies as innovators, with long growth prospects, a product or service that gives a competitive advantage and high profit margins. He adds these are often market leaders, willing to invest in their business and with an ability to create trends that should drive earnings into the future.

Such companies can rise to the recent spike in inflation, Dent adds, due to their “healthy balance sheets, good management, pricing power and robust cost control.”

He says: “As the world retreats from a period of extreme monetary stimulus, the importance of financial strength and good cash generation has all the more resonance.

“Having a strong balance sheet and high profit margins can cushion the blow from rising costs, while conservative levels of debt mean that companies are less impacted by rising interest rates.

“It is our belief that over the long term, whatever the short-term twists and turns in stock markets, earnings drive share prices. Indeed, for the patient investor, the present market volatility is providing opportunities.

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