Mid-cap equities generally remain attractive, but momentum has driven up stocks tied to several hyper-growth industries. The bubble around these stocks began to pop in March, and we believe limiting exposure to those areas of the market will be critical to maximizing returns going forward. Brian Demain, Portfolio Manager of the Janus Enterprise Fund, explains why he believes the greatest opportunity in mid-caps lies with “predictable growth” companies.
Pockets of the mid-cap market are in bubble territory
While we do not believe mid-cap equities are generally overvalued, investors should take a closer look under the hood, as select pockets of the mid-cap market trade at wild valuations not seen since the last tech bubble. The momentum lifting these overvalued stocks ground to a halt in March, and we believe avoiding those pockets will be critical to maximizing returns going forward. In the absence of momentum driving markets, we believe there is greater upside with higher-quality growth companies that have demonstrated an ability to sustain earnings growth over time.
We warned about overvalued pockets of the market in commentaries last fall. We call it the “Theme and a Dream” phenomenon. Stocks tied to hyper-growth themes such as cloud computing and social media have been bid up massively due to excitement about the disruptive nature of these platforms. The growth potential is hard to ignore, making it easy to dream big. Social media is the preferred method of communication for millennials, and offers businesses more effective advertising toward a targeted audience. Meanwhile, cloud computing offers a cheaper, faster and more effective delivery of software solutions. We don’t dispute the game-changing nature of these themes, but investors should be careful about the valuations assigned to seemingly every company tied to them.
Last fall, signs of overexuberance were evident in select areas of the market. Tech IPOs that launched between October to February had an average first-day return of 37%. Looking across the tech sector, many social media and cloud companies yet to produce positive earnings were instead trading at high multiples of revenue. In some cases, the implied revenue growth in these stocks’ valuations was more than they could achieve even if they served their entire addressable market. We believe many of these young companies are bound to stumble along the way, or at the very least face stiffer competition from competitors also attracted to such high-growth markets. As that happens, such companies will have a hard time growing into their current valuations.
Overvalued stocks have retrenched, and may continue to decline
This spring, Theme and a Dream stocks retrenched. Momentum investors who had indiscriminately chased stocks in hyper-growth industries perhaps realized the rapid ascension was coming to an end, questioned the high valuations, and started selling out of positions.
The decline for Theme and a Dream stocks may not be over. Many of these stocks appealed to an investor base purely attracted to momentum driving up the entire group. Such investors are willing to pay an exceedingly high price for the potential growth in a speculative business model. These stocks retreated in March and April as momentum waned, but they still remain overvalued when analyzed using discounted cash flow analysis or other valuation metrics grounded in reality.
The best opportunities lie with predictable growth companies
There is no question cloud computing and social media are game-changing trends. We hold a select few of these stocks we believe will be truly great companies and grow into their valuations, but we believe many other stocks in overvalued pockets of the market may fall further.
Going forward, we believe mid-cap equities will be led by a new set of leaders. The price-to-earnings ratio for the Russell Midcap Growth Index is in line with historical norms, but expanded significantly in 2013 in anticipation of future earnings growth. Now companies will have to demonstrate their ability to grow earnings to achieve further stock price appreciation. This type of market environment favors companies with more predictable earnings growth.
We see opportunity with companies tied to themes that may not be as tantalizing as cloud computing or social media, but where the trends are more developed and the companies that will benefit from them are more established. For example, consumer electronics are penetrating deeper into our lives, and the devices in our homes and automobiles are increasingly communicating with each other, a concept commonly known as the Internet of Things. Microcontrollers and semiconductors that allow these devices to communicate will be in higher demand as such devices proliferate.
Similarly, we believe the growth trajectory of life science tools in the health care sector is more predictable. Such tools ensure better quality control in the operating room or more efficient research and development, and will continue to enjoy steady uptake in the market.
For these companies, we believe the path to growth is clearer than it is for many companies in nascent, hyper-growth industries that were yesterday’s darlings. In the short term, we believe predictable growth stocks will be favored as the market looks for earnings growth to justify valuations. In our view, they will not only provide greater long-term returns, but less volatility.
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