Growth Is Becoming More Valuable by Frank V. Caruso and Christopher Kotowicz, AllianceBernstein
Precious gems, Old Masters artwork and certain brands of scotch: scarcity makes them more desirable and adds to their value. The same can be said of organic growth. As the economic cycle matures, we expect the stocks of companies that have it—and can maintain it—to become increasingly prized.
There are numerous reasons why top-line (and, in turn, bottom-line) growth is in shorter supply these days. While the economy remains relatively healthy, the stimulative punch of low borrowing costs and quantitative easing programs is weakening. Low oil prices, a strong US dollar and the forthcoming tightening of US monetary policy are further headwinds. After six years of slow recovery, there are simply fewer obvious pockets of pent-up cyclical demand to drive meaningful volume gains.
Take, for example, the US auto industry. Annual production has roughly doubled from its recession lows to more than 16 million units today. Even if builds were to rise another 4 million units to 20 million over the next five years—which would be a record high—the cumulative gain would be just 25%, a quarter of the rate of the prior five years. This math holds true for other end markets, with US home construction being one potential exception.
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Interpreting the High Value of Sales
So why is the market attributing such a high value to sales today? Despite slowing aggregate growth rates, the S&P 500 Index is currently trading at a median price-to-sales (P/S) ratio of 2.1 times, a 50-year high (Display 1). This can be interpreted in several ways. It may mean that investors expect today’s near-record profit margins to persist, if not rise further, as a reviving economy keeps sales buoyant. Or it could reflect the market’s valuing of future earnings streams using interest rates that have been falling steadily for nearly three decades (mirroring the ultralow forward yield potential embedded in fixed-income assets). It could also mean that investors anticipate a sharp acceleration in sales growth. In our view, it’s probably some combination of all three possibilities.
Regardless, there’s a lot of hope—and risk—built into current valuations. P/S multiples this extreme haven’t been good for stock performance historically. According to Ned Davis Research, when the S&P 500’s median P/S ratio has exceeded 1.53—which has happened only 18% of the time since 1965 and is well below the current levels—stock prices have been essentially flat one year later (up a mere 60 basis points, on average). If this pattern were to recur, it would pose a tough performance hurdle, whether we’re talking in absolute terms or relative to other asset classes.
Stable Organic Growth to Gain Cachet
As the economic cycle matures, we expect sustainable, stable organic growth to increasingly gain cachet. This stable growth is likely to be highly idiosyncratic—either because the companies possess an enduring competitive advantage (like those with long-established network effects), are forging new markets (from emerging new technologies such as DNA sequencing, which is enabling diagnostics and treatment capacities not possible just a few years ago) or are benefiting from secular changes in existing markets (like airframers and aircraft engine manufacturers riding the aircraft upgrade cycle and the push for greater fuel efficiency).
In our experience, the market consistently underestimates the durability, the ultimate magnitude and thus the underlying value of these idiosyncratic, differentiated growth themes.
In contrast, companies with high sales cyclicality present an elevated risk, particularly at economic inflection points. Though these stocks’ low earnings multiples may appear to be compensating for this risk, the depth and duration of the sales and earnings downturn are often more severe than the market anticipated. We have seen these dynamics play out recently in the global mining industry, which we believe is portending a similar fate for other capital-intensive, long-cycle end markets.
Between two otherwise identical companies, a 1% faster top-line growth rate would be worth an additional 10% to current market capitalization. However, if we are right about the likely divergences in future corporate growth prospects, the valuation gap could be much greater. Accordingly, we see particularly rich payoff potential in well-managed companies that can deliver outsized multiyear top-line growth and high (and hopefully improving) cash returns on investment, and we would avoid companies in more mature, cyclically sensitive end markets. While we believe this focus is a smart strategy at all stages of an economic cycle, we expect sustainable, high-quality growth to be particularly coveted in these times of growth scarcity.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Frank V. Caruso is the Chief Investment Officer of US Growth Equities and Christopher Kotowicz is a Senior Research Analyst at AllianceBernstein.