By Michael Roberge
It's been almost a year since we hit a market bottom after the longest recession in the post-World War II era. While the painful decline in the equity markets caused many investors to lose their appetite for this asset class, those who stayed the course in their equity allocations have benefitted from a substantial rebound this year. Looking ahead, I believe the pace of the upcoming business cycle continues to warrant a place for quality growth stocks among other asset classes in a well-diversified portfolio.
Driven by the uncertainty surrounding the state of the economy and financial markets, in the fall of 2008 companies began aggressively cutting costs to protect margins and profitability. This obviously led to better-than-expected earnings in 2009 and asset prices responded favorably. Within the rally, we have seen significant outperformance by lower quality stocks. Heading into a new year, investors are left wondering if the rally is sustainable and if so, can lower beta stocks maintain their leadership?
While the future is always unknown, fundamental research on companies suggests, to me, a business cycle that may be weak relative to historical standards due to structural issues in the real economy, a fading of fiscal stimuli and likelihood of higher taxes. Against such a backdrop, I feel stocks of quality growth companies offer compelling value. Here's my thesis why: this year many companies were able to generate earnings surprises due to expense management, but I feel top-line growth should be required for equity multiples to expand in 2010. After all, companies cannot continue to just cut costs to remain profitable. As the economy expands, but at a growth rate below potential, growth will be scarce. As a result, I anticipate a rotation away from the stocks of highly leveraged companies with weaker balance sheets, to stocks of well-run businesses who can grow cash flow and earnings. I feel such companies will possess good fundamental traits such as pricing power, a large opportunity set (either by product or customer base), and business models that aren't overly capital intensive. Well-managed growth companies, with product set(s) which aren't commodity-like items, and instead, have high barriers to entry, I feel can grow faster than the market. This could result in a wide dispersion of stock multiples as slower-growth companies' multiples compress while higher-growth companies' multiples expand.
When confronted by a financial crisis, it is human nature to dial-down the risk in a portfolio and this usually entails an emphasis on value stocks and an increased allocation to fixed income. However, in the crisis of 2007-2008, financial stocks in the value category were among the hardest hit, suggesting that a more broadly diversified allocation, including growth stocks, should be considered. This is an important point for all investors, especially retirees and pre-retirees who face longevity risk, higher taxes, and even a return of inflation several years out. Maintaining an allocation to growth stocks is a strategy that can help address those risks, especially considering the backdrop going in to this year.
Michael Roberge is chief investment officer for U.S. Investments, MFS Investment Management.