It’s the end of another quarter, and the great rate debate continues to dictate the path of growth equities. Rising interest rates amongst global central banks have caused a drastic retreat in all major equity indices. We are still experiencing the hangover from binging on too much stimulus, as central banks now look to tighten their belts ahead of (Canadian) Thanksgiving.
There are three events that need to occur to reverse the Fed's hawkishness, giving us any reprieve in equities:
- A slowdown in growth,
- Inflation heading towards the long-term target of 2%, and
- A softer labour market.
While we enjoyed a summer rally to start off the quarter, September closed the quarter in its typical terrible fashion – erasing gains and then some. The culprit that stopped the bear market rally in its tracks was the Jackson Hole Conference. An overly Hawkish Powell did his best Volcker impression by expressing that we must put a lid on inflation "by any means necessary," and he won't stop "until the job is done."
Over Q3, the NASDAQ was down 4.1%, the S&P500 down 5.3%, and the TSX down 2.2%. The macro narrative of a rising rate environment continued to challenge all equities during a summer rally that was reversed in a typically terrible September.
There was too much capital in the system for too long. We should’ve known this when pictures of apes and rocks were selling for millions of dollars, but we also should’ve known this when looking at multiple expansions in high-growth technology stocks.
In this environment: free cash flow compounders will win
There is a strong inverse correlation between the US 10yr and high-growth software multiples. This increase in yield has driven sentiment to retreat entirely from these companies. In February 2021, the high growth cohort of software as a service businesses traded around 40x revenue. However, that multiple now sits at 11x, signalling a large blowout of “air” that was in the system.
It used to be the consensus that the public market could tolerate ballooning multiples as long as the company was able to “grow into its valuation.” This is because software, by its very nature, is a land-grab model. Applications providers solve for a specific pain point, then try and grow their total addressable market (TAM) by upselling and cross-selling products. Once critical mass is achieved, they’d control operating expense (OPEX) by decreasing R&D and S&M as a percentage of revenue.
However, throughout this sell-off, the higher multiples that investors are paying get put under further scrutiny. A lot of this growth is dependent on everyday businesses needing this software for workflow optimization. When the overall economy slows, the growth rate starts to slow in these super-growers as well. In this environment, it is safer to bring cash flows forward through increasing exposure to more mature and larger cap companies—something we’ve done in Purpose Global Innovators Fund.
There will be a time when it will be advantageous to pivot back into these hyper-growth companies, but that time is not now. We need to see a slowdown in CPI, weak GDP numbers, and weak job market numbers, which will ultimately give the Fed permission to dampen their hawkish rhetoric, at which point investors will come back to the table on technology stocks.
For now – stick to free cash flow compounders that can weather the storm.
– Nick Mersch, Portfolio Manager of Purpose Global Innovators Fund
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