A big question facing growth-oriented investors is whether the popular investment style can regain its mojo and get back to winning ways in a world of high interest rates.

Despite a strong recent rally which has seen the technology heavy Nasdaq Composite rise 14% over the last six months, growth stocks have struggled relative to value over the last three years.

The arrival of Pfizer’s (PFE:NYSE) Covid-19 vaccine in November 2020 marked the end of a spectacular performance for growth investing which outperformed value by a whopping 50% over the previous 13 years based on MSCI World Growth and Value indices.

Arguably that era was unusual and characterised by ultra-low interest rates supported by loose central bank monetary policy which is the opposite to what is happening today.

Shares has spoken with a selection of fund managers in the growth investing space and they appear unperturbed by the drag from higher interest rates.

One key takeaway from these conversations is a collective belief that strong company fundamentals trump macroeconomic headwinds.

In other words, companies which demonstrate higher than average returns on capital and operating margins combined with strong cash flow generation have a better chance of outperforming in the long run.

Zehrid Osmani, who runs the Martin Currie Global Portfolio Trust (MNP), concedes that interest rates are a headwind.

However, it is business as usual for Osman who focuses on finding companies which are expected to benefit from high structural growth.

Osman remains wedded to his belief that companies generating high returns on invested capital and strong cash flow growth create more value for shareholders eventually.

The team model different cash flow scenarios over a 20-year forecast horizon and think about where interest rates and inflation might be over the long term.

Reflecting a shift in the team’s long-term view on interest rates and inflation they made a 1% increase in assumptions to 5% and 3% respectively in 2022.

Osman reckons a structural shift higher seems sensible in the light of increased global supply chain costs, higher wage growth and increased investments related to the global energy transition.

HIGHER RATES OFFER BUYING OPPORTUNITIES

Some growth fund managers pay little attention to macro factors because they are deemed too hard to forecast.

Simon Barnard, who manages Smithson Investment Trust (SIT), sits in this camp. ‘At Fundsmith, we don’t make economic predictions because we don’t think that we’re able to reliably invest on the basis of them.

‘Markets are a second order system, so even if our economic predictions were correct we would also need to know exactly what expectations were already priced into the market, which is impossible to know with any certainty,’ explains Barnard.

Instead, Barnard focuses on finding high quality growth companies which are expected to grow their cash flow under any economic circumstances. Double-digit growth still provides an attractive alternative to cash and bonds, argues Barnard.

Fundsmith founder Terry Smith has commented in the past on the importance of higher-than-average margins because they provide more of a cushion during periods of rising inflation.

Taking a long-term view, Fundsmith sees short-term gyrations in share prices as an opportunity to buy quality growth at a knock-down price.

‘Whilst the transition from low interest rates to the current levels has precipitated a recent contraction in the valuation of most assets, particularly growth equities, in many cases, as often happens, the market is now offering some fantastic growth businesses at attractive valuations that we haven’t seen for many years,’ adds Barnard.

WHY VALUATIONS MATTER LESS IN THE LONG TERM

Even diehard value investors like Charlie Munger concede that over the very long term it is not possible for investors to earn more than a company can deliver in terms of cash flow growth.

What Munger is implying is that equity valuations (such as PE) matter less and less over longer time horizons. For example, let’s say blue sky company Rocket trades on a PE of 50 and grows its earnings at 15% a year.

We assume the PE drops by 50% over the next 20 years. This works out at an average annual drag on the shares of just under 2.3% a year.

Over 30 years the drag falls to 1.2% a year. Compared with 15% a year growth, the fall in the PE ratio is a drop in the ocean.

The example assumes the PE sees a slow steady decline over 20 years. Highly valued growth companies which fail to deliver can often see a more dramatic plunge in the PE.

A sudden drop in the PE at the start of the period would make a bigger dent in overall returns. Under this scenario returns drop to 11% from 15% a year.

QUALITY AND GROWTH  GO HAND IN HAND

An implication of successful growth investing is that companies must survive long enough to deliver the expected earnings growth as well have access to capital to finance the growth.

It is therefore not surprising to see growth managers place a big importance on financial strength and quality of earnings in addition to earnings growth.

Businesses with higher-than-average returns on equity and strong operating margins often generate lots of cash which means they can finance their own growth.

This means growth is de-risked from a balance sheet perspective. Carrying little or no debt also means most of the profit is retained for shareholders rather than being paid out in interest to banks.

Schroders fund manager Nick Kissack employs a quality at a reasonable price or QARP style of investing. Kissack looks for businesses with sustainable returns on investment and strong barriers to entry.

Assessing managements and their track record of delivering total shareholders returns is an important consideration for Kissack.

High inflation and rising interest rates have stirred up headwinds for the growth style of investing. But the good news is the investment trust structure can create opportunities for investors as supply and demand imbalances and has left the shares of many growth-focused funds trading on wide discounts to the value of their underlying assets.

In the AIC’s Global sector for instance, popular growth trust Scottish Mortgage (SMT) trades on a 14.3% discount to net asset value (NAV) which reflects disappointing recent performance and a combination of interest rate hikes, fading appetite for higher-risk investments and scepticism over the valuations of its private-company stakes. Scottish Mortgage, which aims to identify, own and support the world’s ‘most exceptional growth companies’, is the sector’s best 10-year share price total return performer. It backs the likes of Elon Musk-steered electric car maker Tesla (TSLA:NASDAQ), ecommerce-to-cloud computing colossus Amazon (AMZN:NASDAQ) and chip designer Nvidia (NVDA:NASDAQ).

Options in the Global Emerging Markets sector include Templeton Emerging Markets (TEM), the largest trust in terms of total assets trading on a double-digit NAV discount, as well as JPMorgan Emerging Markets (JMG), the second best 10-year share price total return performer managed by veteran Austin Forey alongside John Citron, which offers professionally-managed exposure to regions ranging from China and India to Brazil, Indonesia and Mexico. There are also single country funds focused on China, India or Vietnam such as Fidelity China Special Situations (FCSS), India Capital Growth Fund (IGC) and Vietnam Enterprise Investments (VEIL).

The US is renowned as a growth market and trusts focused on this market include JPMorgan American (JAM), which seeks to achieve capital growth by outperforming the S&P 500. Emphasising capital growth rather than income, the fund’s managers can buy smaller cap companies when appropriate.

It is typically easier  for a small company to double its size, and investors’ money, than for a big one to do so. There are several UK small cap trusts with strong long-run performance record such as BlackRock Throgmorton (THRG). Funds on double-digit discounts include the likes of Henderson Smaller Companies (HSL), Montanaro UK Smaller Companies (MTU) and River & Mercantile UK Micro Cap (RMMC). [JC]

FOUR GROWTH INVESTMENT TRUSTS TO BUY

ALLIANZ TECHNOLOGY TRUST (ATT) 281p

Technology has been an extremely popular sector with growth-focused investors for obvious reasons. Tech stocks have a record of generating a steady stream of growth backed by a pipeline of innovation.

Allianz Technology Trust, run from San Francisco by Mike Seidenberg and his team following the retirement of veteran manager Walter Price in 2022, has a bottom-up stock picking driven approach.

It does own the big names you would expect, like Microsoft (MSFT:NASDAQ), Nvidia (NVDA:NASDAQ) and Apple (APPL:NASDAQ), but also some less familiar names like cloud database outfit MongoDB (MDB:NASDAQ) and monitoring and security platform for cloud applications Datadog (DDOG:NASDAQ).

In 2022, performance was affected by a big sell-off in the wider sector but the excitement around the AI theme has helped contribute to a better 2023 and the long-term performance is strong with a 10-year annualised return of nearly 17%. The ongoing charge is 0.7% and the trust is on a 13% discount to NAV. [TS]

BLACKROCK THROGMORTON INVESTMENT TRUST (THRG) 582p

This trust runs a high conviction portfolio giving investors access to exciting UK growth companies with quality management teams and dominant market positions.

The trust has delivered robust performance over the last five and 10-years handsomely outperforming the UK small-cap sector with annualised returns of 3.5% and 7.9% a year respectively. The sell-off in small cap growth companies means the trust trades at a wider than normal 5.8%, representing excellent value.

Fund manager Dan Whitestone has an unwavering focus on finding and investing in differentiated growth companies and industry disruptors that are winning market share.

Uniquely for a smaller companies trust, BlackRock Throgmorton allows Whitestone to short weak companies, such as those disrupted by industry change.

Top holdings include promotions company 4imprint (FOUR), Unified Communications as a service provider Gamma Communications (GAMA:AIM) and international distributer of building materials group Grafton (GFTU).

Industrials and consumer discretionary companies make up over half of the portfolio. The trust has an ongoing charge of 0.55% a year and trades at an 4.8% discount to NAV.

MID WYND INTERNATIONAL (MWY) 713p

This popular trust is a great way to get diversified exposure to quality global growth companies and is trading at a 2% discount to NAV.

The trust is under new management from the beginning of October with Lazard taking over the mandate from Artemis. However, the investment style hasn’t changed and maintains a focus on identifying high quality companies with sustainable profitability.

It aligns well with Mid Wynd’s philosophy of investing at the right valuations into companies which have the potential to compound investors’ capital at attractive and sustainable rates.

The trust has a strong track record delivering a 10-year compound annual growth rate of 10.8% a year, outstripping Morningstar’s Global Large Cap Equity category return of 8.8% a year.

New managers Louis Florentin-Lee and Barnaby Wilson are seasoned stock pickers and co-manage the Lazard Quality Global Growth strategy.

The portfolio is comprised of 41 holdings which in aggregate have demonstrable quality growth metrics displaying higher returns on equity and superior expected earnings growth compared with the MSCI Global index.

Trading at a 2% discount to NAV, the trust has an ongoing charge of 0.62% a year.

MOBIUS INVESTMENT TRUST (MMIT) 132.3p

Emerging markets are typically seen as having greater growth potential due to their less mature economies and, often, more youthful demographics.

Launched in late 2018, this trust has leant heavily on the expertise of its founder, legendary emerging markets investor Mark Mobius.

As Peel Hunt observes: ‘Mark Mobius has been a leading emerging markets investor since the 1980s and his philosophy, integrated into the trust’s investment approach, has helped the trust deliver significant outperformance versus the benchmark and peers since launch five years ago.’

The bad news is he is now retiring (at the ripe old age of 87) and will be replaced by his co-manager and co-founder Carlos Hardenberg. With Hardenberg having worked closely alongside Mobius for years, we are confident the same successful blueprint will be followed.

The trust has a focus on corporate culture and avoids investing in areas like fossil fuels, pornography and weapons. It does not invest in banks. One drawback is the ongoing charge of 1.5% but this is justified by the performance to date in what can be a tricky space. The trust trades at an 8.8% discount to NAV. [TS]

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