Where have all the growth stocks gone? There are now only two stocks in the FTSE 100 that pay no dividends, traditionally a sign of growth stocks: Ocado and M&G. And many of those on low dividends are mature companies such as ABF, Rentokil, Diageo or Compass rather than young growth stocks. This tells us that investors are more willing to pay high prices for safe, established companies than they are for growth.
Our most popular funds take the same approach, favouring big defensives rather than growth. Lindsell Train’s UK equity fund’s biggest holdings, for example, are RelX, the London Stock Exchange, Unilever and Diageo.
Of course, there are several smaller stocks that investors do believe offer growth – perhaps rightly. But they are small. There are very few stocks that have experienced good growth that investors expect to continue. Instead, the market is dominated by old stocks.
Why? It might be that there are few growth stocks because there are few good growth ideas. Stanford University’s Charles Jones says that good ideas "are getting harder to find". This might be due to simple diminishing returns: the best ideas have already been taken. Tsutomu Miyagawa and Takayuki Ishikawa show that the productivity of research and development spending has been falling around the world.
Also, the UK is at a disadvantage relative to the US. It’s no accident that so many big platform businesses such as Facebook, Twitter, Uber and Airbnb should have started in the US. Businesses such as these depend upon network effects; their value rises more than one-for-one with the number of users they have. The mere fact that the US has more people than the UK thus gives it a massive advantage in producing network-dependent companies.
A further problem is that even if there are good growth companies you won’t necessarily find them on the stock market. Back in 1989 Harvard University’s Michael Jensen predicted a decline in listed companies because, he said, they contain “widespread waste and inefficiency” as a result of the “absence of effective monitoring” of bosses by shareholders. This means that, as Liverpool University’s Charlie Cai has shown, growth in sales often lags behind growth in assets, causing profits to fall – sometimes because bosses prefer the easy job of building empires to the trickier one of raising profits. The solution to this, said Professor Jensen, was for companies to be run by private equity.
This is one economic forecast that has proved correct. Rene Stulz and Kathleen Kahle have shown that there are fewer listed companies today than there were a few years ago, and those that are on the market tend to be older and more cash-rich – that is, less like growth stocks.
There’s something else: investors have wised up. The tech crash taught us that growth stocks can be systematically massively overpriced. And that wasn’t a one-off. Yale University’s William Nordhaus has shown that for decades companies got only a “minuscule fraction” of the benefits of innovation: the rest go to workers or customers.
This is simply because growth companies often face so much competition that profits get bid away by rivals. Apple was an exception here because its genius lay not just in innovation but in developing a strong brand, which enabled it to charge premium prices.
Investors have learned from this what Warren Buffett has been saying for years – that what matters is that a company has an economic moat – something that fends of competition and allows it to charge high prices and so maintain profit margins.
This explains why so many stocks on low yields are not growth companies, as was the case 20 years ago, but mature ones. It is these that have established brand names and entrenched market power that give them moats. And investors are willing to pay a premium for these.
Herein, though, lies a danger. In stock markets, learning can go too far, and so underpriced stocks can become overpriced. As MIT’s Andrew Lo has shown, this causes investment strategies to “wax and wane”: in piling into underpriced stocks (as moat shares were a few years ago) investors can ultimately drive their prices up too far with the result that they subsequently fall. This was the fate of small caps: investors realised in the 1980s that they had been underpriced and so bought them, driving their prices up so far that a decade of underperformance followed.
In recent years moats have waxed and growth stocks have waned. There is, however, no reason to suppose that this will continue forever – but equally no sure way of telling when it will end.
