ASX growth shares have been hit hard in 2022 as interest rates prime up for a shift and inflation pressures dominate investor headlines.
Growth shares are companies that are expected to grow at a much faster rate than both competitors and the market, and typically are earlier in their maturity cycle. Most earnings are reinvested back into the company versus being paid in dividends.
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Growth stocks have dominated in recent years
These stocks generally trade at lofty valuations, as measured by price to earnings (P/E). Growth stocks will trade at a P/E higher than the benchmark S&P/ASX 200 Index (ASX: XJO)'s P/E ratio (which currently rests at 18.8x according to Bloomberg).
Much of the reason is that people are prepared to pay a premium 'today' for access to this potential growth into the future. They will forgo returns today for a higher return way out into the future.
In fact, the theme of growth has dominated the investment landscape over the prior decade, primarily as yields on long-dated bonds wiggled lower and real interest rates sunk to nearly 0%.
This means the discount factor that is applied in the valuation of growth stocks has been equally as low. So investors have been happy to pay these premiums, seeing as the valuation seems 'justified'. Some analysts will defend their assumptions with discounted cash flow projections and other methods as well.
But as interest rates and yields on long-maturity bonds start to rise, this hurts the valuations on already 'overpriced' stocks, with a flow-on effect to market prices.
On that front, many market pundits argue that one is 'overpaying' when purchasing these 'overvalued' stocks, and the risk is always going to be a correction down towards the 'fair value'.
And not to mention the high volatility that can be associated with growth – we've seen as much in 2022. After all, there is a trade-off between risk and reward in finance as we know.
We can see this relationship between the yield/interest rate on the US 10yr Treasury note, a proxy used in asset valuations, and the Vanguard Growth ETF (NYSE: VUG). Investors should pay close attention to the inverse nature of how these two proxies trace each other. The relationship is especially tight in 2022.
One fund manager agrees with the market's sentiment and remains adamant his fund's discipline around valuation and seeking out undervalued companies has been integral to its success in recent periods. Let's take a look.
'Sensible cyclicality' this fundie says
Growth shares continue to face headwinds on global equity markets as we roll through the new year. A number of macroeconomic crosscurrents are feeding into the narrative and it all boils down to how asset valuations dance to the tune of interest rates, inflation and the real economy.
Alphinity Investment Management fund manager, Andrew Martin is thinking along the same lines. The fundie notes his firm's performance has benefitted well from its focus on stock valuation.
Speaking to yesterday's Australian Financial Review, Martin noted that his fund had made some recent changes and was running a more balanced portfolio due to the current macro-climate.
"Our valuation and earnings leadership discipline has largely kept us out of the high PE, long duration growth stocks that have been coming off", he noted.
"With upward pressure from inflation on interest rates and discount rates, that still feels the right approach for now, although we are alert to opportunities in great businesses that can get caught up in the general sell-off".
Martin also noted that the recent turbulence in equity markets might have been somewhat warranted, particularly in view of what's in store for investors from 2022 and beyond.
"For now, adding a bit of cyclicality back in (given current inflation and growth outcomes) seems sensible", the portfolio manager said. "Especially shares are the more "value-y" end; so resources, energy, financials".
That leaves Aplinity's principal feeling constructive on a suite of potentially undervalued, defensible names that hold their mark on the ASX.
"However, looking for decently priced defensives such as Amcor, Orora and Medibank would also be prudent", Martin remarked.
