By James Budden

The last two years have been uncomfortable for many investors. The main catalyst for discomfort has been the hasty rise of interest rates to combat spiralling inflation post-Covid. Markets faced severe supply shocks as the world returned to a form of normality after the pandemic driving up prices on the back of a scarcity of goods coupled with previously pent-up demand.

Geopolitics have exacerbated the situation with the war in Ukraine forcing up energy costs for a while. Intermittent spats between the US and China have created uncertainty in the minds of investors and more recently conflict in the Middle East has added to the gloom. Ascending interest rates put an end to a decade of cheap money casting doubt on the ability of growth companies to expand their businesses or indeed survive at all when the cost of finance has increased exponentially.

Yet the world has not yet slipped into recession. 2023 was fine for most markets with China being the outlier in a negative sense – a case of fear or FOMO for investors.

Once again, the US has led the way albeit dominated by the exceptional progress of the Magnificent Seven – Meta, Tesla, Alphabet, Nvidia, Apple, Amazon and Microsoft – up some 80% in share price terms while the rest of the 493 companies in the S&P 500 remained collectively flat. Strong evidence of the power of asymmetric returns.

Inside the doorway of 2024 sentiment still blows against growth investing. However, the headwinds of the last two years may be dissipating.

These have included value compression where stock prices started from very high levels and bumped into rising interest rates, downward revisions as growth stock prices reacted violently to any negative news and a general deceleration of growth as the world adjusted to the post-pandemic environment.

Growth companies have had to adjust to a new paradigm putting emphasis on profitability and generating free cash flows to evidence self-financing of their operations – debt being rather less attractive these days. This demonstration of resilience is in stark contrast to the growth at all costs of the previous decade underwritten by uber-cheap cash. Market share was the aim but now it is all about organic growth and the balance sheet.

Those companies which have responded well to changing circumstances include Shopify, the merchant-focused ecommerce platform which has cut costs and ditched its logistics arm and Door Dash, the food delivery app, which has benefitted from the demise of rivals and delivered close to $900m of free cash flow as a result.

This resilience gives the lie to the stereotypical view that growth cannot thrive when interest rates are high. Quality growth companies with high returns on capital and robust profit margins are well-placed to deal with any lingering inflationary pressures. Such businesses do not simply rely on the economic cycle to excel. They point to fundamental progress which should be recognised by markets over time in share price terms.

This is beginning to happen as earnings and profits exceed expectation. Share prices tend to follow earnings over meaningful periods.

If 2022 was a year of adaptation and 2023 one of execution for growth companies, we may now be heading into a period of recognition where share prices begin to reflect the underlying strength of quality growth businesses.

The digitisation of commerce and finance continues at pace. Companies such as Mercado Libre, Coupang and PDD Holdings are dominating expansion in their respective markets. The confluence of data and healthcare offers the chance to discover new ways to harness the power of machine learning and lend a higher probability to prevention and cure – love it or hate it Moderna is at the fore.

The post-carbon economy is on everyone’s agenda but how to benefit from it is the question.

We see private company Northvolt as strategically important to Europe as a battery maker competing with firms in China and the US. Alongside are Solugen and Climeworks offering solutions to curb future levels of emission.

Then we have the potential of artificial intelligence where the jury is still out as to the winners. As a result, our exposure to AI is diverse and encompasses hardware (ASML), the cloud (AWS), cloud services (Snowflake), industry solutions (Tesla) and the consumer (Spotify).

When this period of recognition takes off it is difficult to forecast with accuracy. Investors are still cautious with interest rates paused and worrisome global and political events bubbling or on the horizon.

The lure of shorter-term and less risky assets such as money market funds and bonds is powerful but for those with a longer-term outlook, equity markets in the shape of growth stocks may prove attractive. In the past investors may have expected to pay a premium for growth but currently (except for the Magnificent Seven) it appears temptingly cheap. Forecasted sales and earnings growth compare favourably to the market while valuations sit below or in line with the average stock.

All of this makes us think it could well be time to board the growth train before it leaves the station.

James Budden is director of marketing and distribution at Baillie Gifford