The looming opportunity in large-cap growth

The U.S. Federal Reserve’s war on inflation has been a headwind for growth stocks in 2023. Higher interest rates lower the present value of a company’s future cash flows, which is a key metric in pricing these names in particular.

It may seem counterintuitive, then, that we are becoming more constructive on large-cap growth heading into 2024. After all, even though the Fed has hit the pause button on interest rates, many forecasters—us included—believe that rates will stay higher for longer. Yes, most of the recent economic releases suggest the economy is already softening, and inflation is plodding toward what we see as the Fed’s unofficial target of 3%. Hence the pause. But a cut is another proposition altogether, one that we view as unlikely in the near term for a variety of reasons including wage inflation, which is still running hot and could result in higher labor costs being passed on to consumers making current levels of inflation stickier.

In other words, we don’t believe the Fed is completely out of the woods yet. And with rates staying higher for longer, refinancing risk becomes a real concern. Companies that participated in the record amount of bond issuance during the depths of the pandemic will soon run up against a maturity wall and will have to either be paid off or refinanced at much higher rates, which could pressure earnings. More than half of all corporate financing comes due sometime between now and 2028.

When viewing the situation through this lens, it becomes clear what companies will need to succeed in a higher-for-longer environment: 1) strong balance sheets, 2) strong cash flow generation and 3) relatively low external financing needs. Dividend payers check all these boxes—but for the growth-minded, large-cap growth stocks are the most compelling. This area of the market has a higher proportion of names that meet all three criteria than perhaps any other.

When you look broadly at large-cap names, variable-rate debt coming due soon represents just a small portion of their books. Less than 10% of large companies’ debt outstanding is variable rate. That number is close to 30% for small companies.

An added factor when considering large-cap growth companies is the innovation argument. You’re paying a relative premium because these companies have a history of being on the bleeding edge of nascent areas of the market that eventually turn into profit centers—think of the early Internet and e-commerce, just to name a couple. Could artificial intelligence turn into the next big technological innovation?

To be sure, most of the factors above have been priced into the stocks to some extent. Although we believe equity valuations are broadly reasonable, there are pockets within the large-cap growth space where some names are stretched. But third-quarter earnings have presented an opportunity to add to these names on weakness. Heading into earnings season, expectations for growth companies were high, and markets have reacted negatively to any perceived weakness—you had to do a lot better than expected and provide a sunny outlook to see any bump in the share price. Most didn’t, and saw their shares suffer as a result.

We think 2024 is shaping up to be a stock picker’s world. Not every large-cap growth company has a clean balance sheet, high cash generation and low external financing. Picking out the true winners requires a keen eye. You just have to know where to look.