Investors turn away from US growth stocks

Stock markets in the US have endured a dismal start to 2022. Since the beginning of the year, the S&P 500 has lost 9.2 per cent of its value, while the tech-heavy Nasdaq is down 14.5 per cent. The main culprits are rising inflation expectations and a more hawkish Federal Reserve, with some analysts now expecting four interest rate rises in the coming year.

Throughout 2021, the Fed was confident that inflation would be a “transitory” phenomenon. But at the end of last year, its chairman Jerome Powell said it was time to “retire that word”. Continued inflation growth in the new year and strong employment data has meant the market now expects more rate hikes in 2022. Goldman Sachs' analysts forecast four rate hikes in 2022, coming in March, June, September and December. In the last month, the yield on five-year US Treasury notes has jumped 27 per cent to 1.58 per cent.

Higher rates mean greater discounts on the present value of future cash flows, which is bad for all companies’ valuations, but particularly bad for growth businesses whose cash flows are expected to be much higher in the future. Cathie Wood’s Ark Innovation ETF (US:ARKK), which invests primarily in growth businesses that are currently lossmaking, has fallen 27 per cent in the past month.

Is the 'bubble bursting'?

Although growth stocks are taking the biggest hit, all US equities have been the beneficiary of ultra-loose monetary policy in the past decade, not least since the pandemic lows of March 2020. This has led some to believe the US has been in ‘bubble territory’ for the past year.

“During the [past] year, the bubble advanced to the category of superbubble, and the potential pain has increased accordingly,” Jeremy Grantham, chief investment officer at US investment manager Grantham Mayo Van Otterloo (GMO), wrote in a blog post titled Let the Wild Rumpus Begin.

According to Grantham, this is the third superbubble the US has ever experienced. The Shiller ratio, named after Nobel-prize-winning economist Robert Shiller, calculates prices relative to average inflation-adjusted earnings from the previous 10 years. The S&P 500 ratio is currently 36. It has twice before been above 30: in 1929, just before the Great Depression, and in the late 1990s prior to the dotcom bubble bursting.

In 2000, technology stocks lost 83 per cent of their value. The parallels may not be exact, but the January sell-off has done little to bring valuations back down to earth. “We can project that the S&P 500 would have to lose about 70 per cent of its value here  simply to touch the run-of-the-mill valuation norms,” wrote Dr John Hussman, president of Hussman Investment Trust. He added, however, that “nothing in our discipline relies on valuations ever visiting those historical norms again”.

'Lockdown stocks' hit badly

Netflix (US:NFLX) and Peloton (US:PTON) are two ‘lockdown stocks’ that have particularly suffered. Peloton’s share price has fallen 17 per cent in the past week since CNBC reported it planned to halt production of its bikes due to low demand. The company denied that report, but slowing demand was borne out in its second-quarter results, as revenue came in just below guidance. 

An adjusted Ebitda loss of $260m (£192m) was an improvement on an anticipated loss of around $350m, but Peleton had ramped up spending to meet demand and now faces a cash crunch. “It only has $1bn of cash on the balance sheet. It’s a lossmaking business so will churn through that quickly, and with a depressed stock market, it will make it much more difficult to raise money in the public markets,” said Stephen Yiu, manager of Blue Whale Growth Fund.

Netflix had one of its most successful years in terms of content creation in 2021. Squid Game, The Witcher and Don’t Look Up were all huge hits, but, after forecasting slowing growth in subscribers, its share price has fallen by 28 per cent in the last week.  

In the fourth quarter, it added 8.3m new subscribers, which was a little below the expected 8.5m. The bigger issue, though, is that management has forecast just 2.5m more subscribers in the current quarter, down from 4m the year before. To try to offset this, Netflix has increased prices in the US, but with $15bn of debt and negative free cash flow, it looks particularly vulnerable in a higher interest rate environment.

Cryptocurrency exchange Coinbase (US:COIN) and retail investor platform Robinhood (US:HOOD) both increased users during lockdown as bored investors stuck at home logged on to purchase cryptocurrencies and equites. But the stock market sell-off provides a double hit to their valuations. Not only do rising rates impact their future cash flows, but stock market declines also typically lead to a fall in activity by retail investors.

In the last month, Coinbase's shares are down 34 per cent and Robinhood's shares have fallen 29 per cent.

The quest for quality

Investors are looking for companies with strong cash flows that don’t have to rely on financing either from debt or share placements. “Microsoft is a great business because it is growing and can finance this through its strong cash flow,” said Yiu, who has Microsoft as one of his fund's top 10 holdings. Cash-generative businesses Alphabet (US:GOOGL), Mastercard (US:MA) and Nvidia (US:NVDA) are also included in the fund.

Microsoft has just agreed to purchase Activision Blizzard (US:ATVI) for $68.7bn in what would be the largest deal in gaming industry history. This is only just over half the cash it had on its balance sheet at the end of 2021. In its second-quarter results on Tuesday, the tech company announced that revenue and operating profit were up 20 per cent and 24 per cent, respectively. In a sign of investor nervousness, Micosoft shares initially fell on what were perceived as solid but not stellar results, before upbeat guidance on its post-results analyst call sparked a sector-wide rally.

Brokers are now expecting 2024 earnings per share of 1251¢ for Microsoft, up around 60 per cent from 797¢ in 2021.  

But Grantham at GMO is looking outside the US for returns. “We have concentrated our exposure to non-US value stocks globally, including those in emerging markets and Japan. To us, these stocks look very cheap relative to the US."

Emerging market equities and value shares in Japan, particularly smaller Japanese value companies are "attractive in absolute terms as well", he said.