From fast growth to prudent growth: A changing road map for mid-caps
Portfolio Manager Brian Demain, CFA, explains why the mid-cap roadmap of the past decade could use updating as the investment environment shifts dramatically.
5 minute read
- The benign “2-2-2” environment of the past decade − roughly 2% inflation, 2% interest rates, and 2% GDP (gross domestic product) growth – is evolving into one of higher inflation, higher rates, and higher nominal growth.
- The prior backdrop was exceptionally favorable for growth, but as capital becomes scarcer, we believe both companies and investors will need to transition their mindsets.
- Assessing which companies are able to affect this transition and adapt will be key to identifying winners and losers in a changing mid-cap market.
Our experience from previous market cycles has taught us that the leaders of the next bull market are not always the same as the leaders of the prior bull market. When the dot-com bubble burst in the early 2000s, the bull market from 2003 to 2007 was not led by technology, media, and telecommunications names, but instead by financials and materials stocks. Following the Global Financial Crisis (GFC), leadership again shifted to growth stocks broadly, and the technology and healthcare sectors specifically.
These corrections in the market are often a reaction to excess capital flooding into a sector. While those excesses take time to work through, other areas of the economy that have been starved of capital have the potential to earn a healthy return. We believe this type of transition is now underway in mid-cap growth equities.
A glorious time
From the GFC through COVID, we lived in a relatively stable − and historically unprecedented − economic period. There were powerful disinflationary forces at work: technology offering price transparency, the movement of industrial production to low-cost China, high levels of immigration and labor participation in the U.S. boosting the labor force, flat-to-declining commodity prices, and a focus on debt reduction by consumers after the GFC. These forces allowed the Federal Reserve (Fed) and other central banks to keep rates exceptionally low and engage repeatedly in quantitative easing (QE) without creating substantive inflation. The decade of “2-2-2” – roughly 2% inflation, 2% interest rates, and 2% GDP (gross domestic product) growth − created an exceptionally favorable backdrop for growth equities: capital was available and cheap, and far-off cash flows were discounted at low rates.
The end of 2-2-2
Several dynamics have recently conspired to end the world of “2-2-2”. The supply chain havoc unleashed by COVID, coupled with more confrontational U.S.-Chinese relations, has ground globalization to a halt and paused incremental capital flow into China. Now, certain strategic industries, such as semiconductors and green energy, are being incentivized by the U.S. government to put capital to work domestically, which is decidedly inflationary. Immigration has slowed dramatically, labor force participation remains stubbornly below pre-COVID levels, and a wave of baby boomers is set to retire in the coming years, underpinning structurally tighter labor supply. Commodity prices, though inherently volatile, have become unmoored from the flatter levels of the 2010s. Lastly, consumer debt as a percentage of GDP is no longer shrinking, removing another deflationary force from the equation.
Redrawing the mid-cap road map
What this all means is that the investing rules have changed. Inflation matters again. The unemployment rate will rise and fall with business cycles, but the labor market will be structurally tighter. U.S. industrial production will, while remaining cyclical, likely be a growth cyclical for the first time in 20 years. The Fed will spend much more time in the 2020s than it did in the 2010s off the lower bound of its policy rate. We believe nominal growth in the economy will be higher, discount rates will be higher, and capital will be scarcer. We believe these factors should compel investors to look more broadly for growth stocks in areas of the market where growth has been less common. In other words, we believe there will be significant opportunities, but investors will need to turn over new stones to find them.
Mid-cap stocks have now readjusted from prior years’ unprecedented valuation levels where certain areas of the benchmark became exceptionally risky − but we think real risks remain. Entering what we believe to be a more balanced market environment, valuations will matter again. We believe primary capital and fundamental results will ultimately cause stock prices to converge on fair value, but the dispersions to fair value are clearly increasing. While this creates more idiosyncratic risk, it could also provide a fruitful backdrop for fundamental stock picking.
From fast growth to prudent growth
The growth that many software and consumer internet businesses delivered through the 2010s and up until the COVID boom was unlike anything seen in the history of capitalism. Whether railroads in the mid-1800s, oil in the late 1800s, cars in the early 1900s, consumer products in the 1950s and 1960s, or retailers in the 1980s and 1990s, booming industries have generally been “real-world” businesses. They could only grow as fast as they put their physical capital to work. However, digital businesses – both software and internet – could potentially grow at exceptional paces for extended periods because they could achieve scale without additional capital.
Software and internet are still healthy growth industries, but some of the outsized growth of the past decade may be a thing of the past as application Software as a Service (SaaS) and e-commerce markets mature. This is relevant because very rapid growth can forgive a lot of sins below the revenue line. When a business is growing revenue rapidly, changes in operating margins are much less important than whether that pace of growth can continue for one more year. However, as growth decelerates, unit economics start to become a more important driver of business value relative to topline growth.
Now, many software and internet companies need to make a transition from a fast-growth mentality to a profitable, measured-growth mentality. This involves difficult decisions about which products to launch and which ones to kill, how to measure customer lifetime value, and how to rein in stock-based compensation, as well as a different mindset than simply “how do we grow faster?” Certain companies will be able to affect this transition, but many will not. Now, and moving forward, assessing this will be key to identifying winners and losers in the mid-cap market.
Growth stocks are subject to increased risk of loss and price volatility and may not realize their perceived growth potential.
Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.
Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.
Idiosyncratic risks are factors that are specific to a particular company and have little or no correlation with market risk.