Growth stocks will be challenged in 2022

In 2021, Investors were twice reminded that higher interest rates for equities that are priced on rather aggressive implied growth rates can plummet. But both times equities have come back, supported by strong earnings growth this year, as the economy came roaring back from the abyss in 2020.

In the past couple of months, we have seen multiple examples of growth stocks tumbling on earnings releases, due to what has generally been seen as a response to narrowly missing revenue growth figures. But in our opinion, this is actually not the right reason growth stocks have been sent on a downwards trajectory. Rather, it is the lack of improvement in operating margins that’s the culprit – and that is going to be a major theme within growth stocks in 2022.

One figure to put attention to connected to this is equity duration, which essentially is an expression of how sensitive a given equity is to increases in another financial figure, otherwise referred to as the discount rate – in this case the US 10-year yield. Many fast-growing growth companies have an equity duration of around 15-20, and some fast growing, but not profitable, companies may have equity duration of around 25-30, meaning that they in theory see their shareholder value go down by 15-20% or 25-30% if the US 10-year yield goes up by 100 basis points – or 1%.

The only way to offset that impact is by either improving the money earned by a company, i.e. revenue growth, or the amount of money you earn per dollar you spend, i.e. operating margin. The former is difficult when growth is already high and fiscal headwinds are likely to play a role next year, lowering the growth momentum. On the positive side, China is beginning to stimulate its economy, which could push growth in the right direction.

Still, the more likely scenario is that increasing growth in companies that already experience high growth in the current macro environment will struggle to improve revenue growth. That leaves the operating margin at the core of offsetting higher interest rates next year, should the bond market finally close the gap with inflation expectations. But improving operating margins might be difficult with wage pressures at unprecedented levels not seen since the 1970s and rising input costs from commodities and electricity.

The combination of potentially higher interest rates and difficulties improving operating margin from already high levels for many companies might prove too difficult or even impossible. That is likely the reason investors are reducing their exposure to growth companies and instead search for safe havens in mega caps as these companies have a better chance of preserving, or even increasing, their operating margin. Microsoft is a recent example, showing its market power signaling a steep increase in its price on some of its software.

We continue to recommend investors to reduce growth exposure and balance the portfolios with companies in the themes such as cyber security, logistics, semiconductor, agriculture, energy, financials, mega caps, and India. Overall, next year will prove difficult for equity investors with more volatility, less direction, and the battle between interest rates and profitability.