The recent selloff of US growth market darlings reflects increasing questions about whether their growth potential still justifies exceptionally high valuations. Away from the froth, growth investors can still find solid return potential in quality companies with profitable, sustainable business models.
The Russell 1000 Growth Index soared by 81.1% from its March 22 low through December 31, led by a concentrated group of mostly tech companies that benefitted as digitization enablers throughout the COVID-19 crisis. However, the strong momentum seems to be faltering so far this year. By the end of February, the growth benchmark was down 0.8% year-to-date and several of its largest constituents were trading 15-20% below their recent highs.
The recent selloff follows a period of equity market speculation in 2020, from record-breaking IPOs to explosive retail investor participation. Valuations of hyper growth stocks have reached near 2000 tech bubble levels, according to their economic price to earnings, a measure that is based on cash flows to assess a company’s underlying economic worth more accurately than earnings-based metrics (Display left). Meanwhile, unprofitable businesses significantly outperformed profitable ones (Display right). All told, these trends further exacerbated the disconnect between company valuations and fundamentals that had been developing even before the pandemic.
Many investors question the sustainability of such high valuations, especially if interest rates rise and business conditions improve for other industries. The pandemic’s biggest winners may also be challenged to meet the market’s lofty growth expectations amid tough year-over-year revenue and earnings comparisons. Where are growth investors supposed to turn now? In our opinion, they ought to turn to companies with the same fundamental strengths that were attractive during the runup—provided they follow the right clues.