With a surge in large growth stocks like Nvidia, the growth fund trend is back in full swing. But investors are starting to question if they’ve missed the boat. Fear not, there are still ways to get in on the action without getting burned.
The Resurgence of Growth Stocks
Thanks to the artificial intelligence trend, the resolution of the debt-ceiling crisis, and a booming U.S. economy, large growth stocks have experienced a tremendous resurgence this year. Chip maker Nvidia is a prime example with its impressive performance.
Tech Stocks Lead the Way
The Nasdaq 100 index, which is made up of many tech stocks, has soared by 38.8% as of June 30. Even popular tech giants like Microsoft have reached record highs, fully recovering from last year’s downturn. This is all the more impressive considering the higher interest rates and the expected decrease in valuations.
The Mirror Image of 2022
In a stark contrast to 2022, when value stocks outperformed growth stocks, this year has seen growth funds dominate. Morningstar’s average large growth fund, with a significant tech stock weighting of 37%, has already surged by 24%. Technology funds have fared even better with an average gain of 30%. Even the Invesco QQQ exchange-traded fund, composed of 51% tech stocks, has climbed by an impressive 39%. Meanwhile, the S&P 500 index has seen a modest increase of 17%, and large value funds have lagged behind with a mere 5% gain.
Second Quarter Success
The trend has continued into the second quarter, with large growth and technology emerging as the best-performing mutual fund categories. Large growth funds have seen an impressive 11.0% gain, while technology funds have notched up a solid 9.9% increase.
But Is It Too Much, Too Soon?
The remarkable surge in growth stocks raises a crucial question: have growth-stock funds reached their peak too quickly?
According to Chris Brightman, CEO of Research Affiliates, the current growth-stock valuation is at an extreme level that has only been observed a couple of times in history. The aftermath of the 2020 pandemic crash and the late 1999 tech bubble come to mind. With his investment strategies influencing $120 billion in assets, Brightman’s observation is worth noting.
So, if you’re considering joining the growth fund craze, tread carefully. While the opportunities may be enticing, it’s important to approach them with caution and evaluate the potential risks.
The Dichotomy between Growth and Value Stocks
The average stock in the MSCI USA Growth Index currently boasts a significantly high trailing price/earnings ratio of 37.2. In contrast, the MSCI USA Value Index has an average price/earnings ratio of 16.7.
The Downfall of Growth Stocks
Last year, growth stocks suffered greatly due to the surge in interest rates. As interest rates increased, investors demanded greater immediate profitability from stocks compared to bonds.
The earnings yield of a stock, which is comparable to a bond’s yield, is the inverse of its price/earnings ratio. As interest rates soared, the 30 P/E tech stocks with a 3.3% earnings yield appeared less appealing when one-year Treasury bills offered a 5% yield. In contrast, value stocks with a 15 P/E and a 6.6% earnings yield still retained some allure.
The Changing Landscape
However, once interest rates reach their peak, the dynamics shift. Wall Street predicts that the Federal Reserve’s decision to implement rate cuts will stimulate the economy during the anticipated recession. In this scenario, high-P/E stocks become more attractive relative to bonds. Conversely, weak and debt-laden companies, as well as cyclical entities reliant on economic growth, tend to fall into the category of value stocks, which may not fare well during recessions.
According to Sonu Kalra, investment manager of the $47 billion Fidelity Blue Chip Growth fund (FBGRX), the recent performance of growth companies is partially attributed to the expectation of potential interest rate moderation. Kalra further explains that the resurgence of the tech sector is not solely reliant on this factor. During the initial stages of the Covid outbreak, tech companies witnessed an increased demand for their services as a result of remote working arrangements. However, they were forced to adapt as their earnings growth waned amidst the decline of the pandemic.
High-Quality Growth: Navigating the Slow-Growth Environment
The current business landscape has posed unprecedented challenges for growth companies. Many have come to acknowledge that we are operating in a distinctive, slow-growth environment. As a result, these companies have taken proactive steps to adjust their cost structures, adapt to market conditions, and ensure their long-term viability.
A prime example of this adaptability is Meta Platforms (META), formerly known as Facebook. Recognizing the need for change, the company implemented a 25% reduction in headcount at the end of last year. As we fast forward to 2023, the tough decisions made by these companies are proving fruitful, leading to notable improvements in profitability. Meta stock has surged by an impressive 145% this year, bouncing back from a disappointing 64% decline in 2022.
Defining Quality in Today’s Market
In an environment characterized by slow growth and high interest rates, companies that exhibit consistent profits and maintain low debt levels are expected to thrive. Moreover, these companies should also be capable of weathering a significant recession, commonly referred to as a “hard landing,” should one occur—an outcome that some market watchers still anticipate.
However, the definition of quality has become somewhat diluted and misunderstood. According to Brad Klapmeyer, manager of Delaware Ivy Large Cap Growth (WLGAX), the prevalence of the term ‘quality’ in the market makes it challenging to be a differentiated large-cap growth quality manager.
Seeking Companies with Economic Moats
Klapmeyer’s investment strategy centers around identifying companies with robust economic moats surrounding their businesses. These moats not only safeguard these companies against competitors but also ensure enduring long-term earnings growth. Instead of solely focusing on stock price momentum or surpassing quarterly earnings estimates, Klapmeyer places greater emphasis on factors such as strong management and competitive advantages.
Note: All returns mentioned are as of June 30. Five-year returns are annualized. N/A denotes not applicable.
A Look at Quality Growth Investing Strategies
When it comes to investing in quality growth stocks, some well-known names like Microsoft, Apple, and Amazon.com tend to dominate the headlines. However, there are a few notable omissions that deserve attention as well. According to one professional, Jeffrey Klapmeyer, companies like Tesla and Meta face significant competitive challenges that cannot be ignored.
Klapmeyer argues that the auto industry has always been fiercely competitive, which casts doubt on Tesla’s valuation. While the stock is already credited with having a unique distribution network, advanced battery technology, and fully self-driving capabilities, Klapmeyer believes that there is not enough evidence to support these claims yet. Similarly, he does not see any distinctive features in Meta’s social-media platform compared to its competitors.
On the other hand, Klapmeyer highlights Microsoft as a market leader in several compelling trends and technologies. With its subscription-based software programs like Microsoft 365, cloud computing services, and investments in AI through OpenAI (ChatGPT’s creator), the company holds a prominent position in the market. As a result, Microsoft makes up 14% of Klapmeyer’s portfolio.
For quality growth investors, low or no debt is a crucial consideration. David Nicholas, a manager of the Nicholas Fund, emphasizes the importance of focusing on companies with good cash flow and lower debt on their balance sheets. This strategy provides stability and helps weather economic downturns effectively.
The Nicholas Fund is known for its quality-focused approach, which has proven beneficial during market downturns but can lag during periods of significant rallies. Another fund that offers similar downside protection with less speculative upside is the Jensen Quality Growth fund. This fund typically invests in a carefully selected portfolio of 25 to 30 high-quality blue-chip stocks that demonstrate reasonable valuations and a minimum annualized return on equity of 15% over the past decade.
Additionally, investors seeking exposure to quality growth stocks at lower costs can consider “smart beta” index ETFs that employ rules-based quantitative screens. One such option is the American Century U.S. Quality Growth ETF (QGRO), which has shown defensive characteristics and boasts a modest 0.29% expense ratio.
In conclusion, quality growth investing strategies involve careful selection of companies with strong fundamentals and favorable growth prospects. While popular names grab headlines, it’s essential to identify competitive challenges and focus on companies with low debt and sustainable cash flow patterns. By employing these strategies, investors can navigate market fluctuations and potentially achieve long-term success.
Outperforming Peers in 2022’s Downturn
The Importance of Index Funds
In the current market climate, where downturns are prevalent, investors are looking for reliable investment options. While traditional low-cost growth index funds like Vanguard Growth ETF (VUG) and iShares Russell 1000 Growth (IWF) offer appealing expense ratios of 0.04% and 0.18% respectively, there is a crucial consideration to be made regarding the concentration of these funds.
Dangerous Concentration Risk
It is worth noting that a significant 25% of these index funds are allocated to just two stocks: Microsoft and Apple. As the market evolves and new favorites emerge, the heavy dependence on these two stocks may pose a risk. According to Nicholas, an industry expert, such concentrated stock weightings can be perilous. He emphasizes the importance of diversification and warns against potential vulnerabilities arising from overexposure.
Valuation Discipline and Active Management
Active managers, on the other hand, have strategies in place to mitigate risks associated with market fluctuations. These managers employ valuation discipline, which helps make informed decisions about stock selection. Brightman from Research Affiliates draws a parallel between Nvidia’s current situation and Cisco Systems during the dot-com bubble of 1999. He identifies Nvidia as having a promising business but an overvalued stock, cautioning against investing at the peak. He indicates that investors who entered the market during late 1999 with Cisco experienced meager returns to this day.
Diversification with Midsize Tech Companies
In light of these concerns, many active fund managers, including Nicholas, have taken measures to reduce their exposure to concentrated holdings. While the fund does hold Nvidia to some extent, its weighting is significantly lower compared to popular growth ETFs like Invesco QQQ. Instead, the management team has been actively investing in lesser-known midsize tech companies that show promise. Examples of such investments include digital advertiser Trade Desk (TTD) and cybersecurity company CrowdStrike Holdings (CRWD).
Exploring Opportunities with Small-Caps
Investors are now considering the virtues of investing in smaller companies. These entities offer greater room for growth compared to the dominant market players commonly known as the “magnificent seven,” namely Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta, and Tesla. By venturing into the small-cap space, investors can diversify their portfolios and potentially capitalize on emerging opportunities.
A Balanced Approach for Risk-Conscious Investors
Disciplined Growth Investors (DGIFX) stands out as one of the best growth funds for investors who prioritize risk management, especially during market downturns. What sets this fund apart is its strategic allocation, with approximately 35% of its portfolio invested in bonds to provide stability alongside its more volatile stocks. Additionally, the fund’s managers place great importance on valuations and focus primarily on mid- and small-cap stocks. This well-balanced approach has contributed to the fund’s impressive track record, outperforming 97% of its peers in Morningstar’s Moderately Aggressive Allocation category over the past decade.
Seeking Sustainable Growth
Disciplined Growth’s primary goal for its stock investments is to achieve a solid 12% annualized return. To achieve this, around 9% to 10% of the performance is typically derived from a company’s earnings growth, with an additional 2% to 3% coming from acquiring undervalued shares.
A Different Perspective
What sets Disciplined Growth apart is its distinct mindset when it comes to stock selection. The fund tends to steer clear of pricier and slower-growing large-cap companies, a departure from popular trends. While many investors chase after AI stocks, Disciplined Growth’s portfolio includes only one prominent name in this field – Super Micro Computer (SMCI), which has seen a remarkable 554% increase over the past year. However, the way the fund’s managers approached this investment reveals their unique philosophy. Lead manager Fred Martin explains, “We remained steadfast for 12 years, enduring challenges along the way, and now it’s finally paying off.”
Embracing Hidden Gems
Rather than relying on well-known companies, Disciplined Growth focuses on lesser-known gems that possess promising potential. One such example is IPG Photonics (IPGP), a laser-welding equipment manufacturer. Jason Lima, a co-manager of the fund, shares his excitement about IPG’s revolutionary hand-held laser welder, which is disrupting the market. Lima highlights that this innovation addresses the current shortage of professional welders while enabling individuals to perform high-quality welding work with minimal training.
Steering Clear of Low-Quality Investments
In an ever-challenging investment landscape, Disciplined Growth holds firm to its commitment of avoiding poor-quality investments. By adhering to disciplined growth and valuation strategies, the fund may bypass the allure of junk investments, ensuring a strong focus on sustainable growth.
Small-cap growth companies can be a risky choice for investors due to the prevalence of poor-quality options. According to Mark Thompson, manager of the successful William Blair Small Cap Growth fund (WBSNX), about 32% of companies in the benchmark index, the Russell 2000 Growth, are technically unprofitable. Thompson refers to some of these companies as “zombie companies” that will need to raise more capital to survive, which is not ideal in a higher-rate environment. However, there are still companies within this sector that show promise and potential for growth.
For those seeking a low-cost index fund, two options worth considering are the SPDR S&P 600 Small Cap Growth ETF (SLYG) and the SPDR S&P 400 Mid Cap Growth ETF (MDYG). These funds have more selective S&P benchmarks that require companies to be profitable in order to be included. However, it’s important to note that many active small- and mid-cap funds often outperform these benchmarks by a significant margin.
One standout fund in this category is the Needham Aggressive Growth (NEAGX). Fund manager John Barr focuses on the long-term growth prospects of small, young tech companies, which make up 64% of his portfolio. Despite the heavy tech weighting, Barr’s fund has shown defensive qualities, experiencing less downside in falling markets and more upside in rising ones compared to its peers in Morningstar’s Small-Growth category over the past decade.
While Barr has held popular artificial intelligence-driven names like Super Micro Computer and PDF Solutions (PDFS) for years, he also seeks out undervalued tech investments such as software company Unisys (UIS), which has seen a 21% decline this year. According to Barr, the market is undervaluing Unisys’ ClearPath Forward legacy operating system. His cautious approach to valuation has proven beneficial during past market downturns.
The Case for More-Aggressive Funds
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Spear Alpha: The Best-Performing Actively Managed Stock ETF
Spear Alpha (SPRX) is an aggressive pure tech ETF that has emerged as the best-performing actively managed stock ETF this year, with impressive gains of up to 54%. Despite launching in August 2021, just before the market crash, the fund currently manages $9 million in assets.
Beating Established Competitors
While Spear Alpha might not have the same level of assets as established players like ARK Innovation ETF (ARKK), it has outperformed both ARKK and ARK Next Generation Internet (ARKW) consistently. ARKK, which launched in 2014 and manages $8 billion, focuses on investing in high-octane stocks but experienced a 67% decline last year. In contrast, Spear Alpha only fell by 45% during the same period. This year, ARKK is up by 41%, but still, Spear Alpha has managed to surpass its performance.
The Expert Behind Spear Alpha
The success of Spear Alpha can be attributed to manager Ivana Delevska, who boasts an impressive track record. With previous experience as a senior analyst for renowned hedge fund firms such as Citadel Asset Management and Millennium Management, Delevska has proven to be skilled in navigating the ups and downs of volatile tech stocks. Unlike more conservative managers, she embraces an aggressive trading approach, evident in the fund’s high turnover ratio of 262%. Delevska strategically trades her favorite stocks, selling them when they become overpriced and buying back in during declines.
One notable example of Delevska’s tactical trading is with Nvidia. Since the fund’s launch, she has employed a strategy of buying and selling Nvidia based on market conditions. This strategic approach has benefited Spear Alpha, as ARK Innovation sold its Nvidia position earlier this year, which proved to be detrimental to their performance. Additionally, Delevska has recently added Zoom Video Communications (ZM) to her portfolio as a “value idea.” Despite a 37% decline in the past year due to easing pandemic concerns, Delevska sees potential in the former Covid market darling.
Considering the success and unique approach of Spear Alpha under the management of Ivana Delevska, investors may want to explore the benefits of more-aggressive funds. While past performance does not guarantee future results, Spear Alpha’s track record and ability to outperform established competitors showcase the potential opportunities offered by a well-executed aggressive trading strategy.
The Challenge for Investors in the Aftermath of 2022’s Market Downturn
The recent market downturn in 2022 proved to be quite a challenge for investors. Even the usually well-diversified iShares Russell 1000 Growth experienced a significant drop of 29%. In the midst of this bloodbath, a new player emerged in the investing arena: Spear Alpha.
Gaining Insights from Turbulent Times
Delevska, the founder of Spear Alpha, considers herself fortunate to have launched her product just before the crash. She believes that it is important for people to witness how a product performs during a downturn. It provides valuable insights and can help instill confidence in investors.
Building Towards Future Success
Despite the hardships faced by investors, Delevska remains optimistic about the future of her ETF. If the market experiences a soft landing, she envisions her product amassing billions in assets instead of millions.