Why Have Growth Stocks Performed So Well?
While the global economy remains impacted by the COVID-19 crisis, equities have rebounded significantly since the lows of March. We have often been asked why equities and growth stocks in particular have performed so well, in some cases making new all-time highs. As long-term focused investors, we acknowledge that there has been business disruption that will likely continue at least through the third quarter of 2020. Nonetheless, when we value growth companies on a long-term basis, the economic losses of the current year represent a small percentage of the long term value of a company. In many cases this year we have seen stocks drop by more than the calculated impact to their share prices. In a few cases, where companies are actually benefitting from the COVID-19 crisis, we have seen growth accelerate, and while we expect the growth to moderate, we believe these companies will be growing off of a higher base level. To illustrate these points we use the value of a growing annuity formula:
Value = Cash Flow / (k-g)
In this formula, k represents the cost of capital and g represents the company’s growth. In our opinion, the value of annuity is the most important formula for investing. With it we see that value is increased by improving margins (and hence cash flow), reducing cost of capital, and growing the business. In the past, we have demonstrated the power of growth in valuation versus achieving higher margins today. Revisiting this point, consider the following example:
As we can see from the above, the long-term growth rate of 4%, despite 20% lower current year cash flow, has a huge impact on the current year multiple and creates higher present value. This illustrates the power of growth. The higher multiple indicates much of the value is from future cash flows.
Now consider three scenarios from an economic shock such as COVID-19. For each of the three companies, assume that expectations were as follows at the beginning of the year:
- Cash Flow $10
- Long-Term Growth Rate: 3%
- Cost of Capital: 11%
Value = $10/(11%-3%) = $125 and 12.5x Current Year Cash Flow
The impact from the economic shock, however, is different for each of the three companies:
Company 1:Cash flow is reduced by 20% to $8 this year. Next year cash flow recovers to $10 and growth resumes to 3% thereafter. The new value consists of $8 of cash flow in the current year plus the value of the long term annuity starting next year and discounted to the current year.
The impact to valuation is -3.5% so any sell off in the stock in excess of 3.5% indicates a buying opportunity. In our opinion, any sell off greater than 3.5% can be interpreted as an increasing cost of capital for the market overall due to the difficulty of calculating the impact to current and future estimates. We also note that using multiples-based valuations on the current year, which is seeing a near term impact to results, could lead to the wrong investment conclusion. In this case we see that the price to cash flow for the current year is 15.1x due to the reduced expectation. That is higher than the 12.5x multiple calculated before the economic impact. As we move forward in time, the current year is no longer part of the present value calculation. The stock can rebound back to prior value and appreciate over the longer term because of the growth. |
Company 2:Cash flow is reduced by 20% to $8 in the current year, growth resumes next year at the long term growth rate of 3%, but off a lower base.
In this case, loss of value is 20% and any sell off in excess of 20% is a buying opportunity. In this situation, it will take time for the stock to recover because it will take time for the cash flow run rate to be restored. |
Company 3:This company has products and/or services that are needed during the crisis and sees cash flow increase 20% in the year to $12 as a result. Growth is expected to moderate back to its long term rate next year but on a higher base. The base level of revenue increases because the crisis was a unique opportunity to accelerate customer acquisition.
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In our view, successfully investing in challenging economic times like now requires long term insight into how business models will recover in future years and then opportunistically taking advantage of the market’s misinterpretation of businesses’ fundamentals.
We continuously survey the investment landscape by drawing upon our deep technical knowledge to assess the business models of our investment universe and have not deviated from our fundamental research efforts during the recent period of market volatility. We acknowledge that there will be near-term business disruptions from the COVID-19 virus, but the companies that we target remain well positioned to grow over a multi-year time horizon. We believe that these companies best position us to help our clients achieve their investment goals. As always, we appreciate your confidence in and support of TCW’s equity strategies.
Disclosure
This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2025 TCW