How Will Growth Stocks Perform During A Recession?

Inflation Concept

Ibrahim Akcengiz/E+ via Getty Images

Growth has been very sensitive to the sell-offs that started after the Fed’s June meeting, and before that reversals in key FANG names like Netflix (NFLX) also hobbled the category’s performance with much of the pandemic excitement for tech names reversing. Indeed, with many growth stocks representing ownership in companies that are yet to produce sustainable cash flows, there are some vicious cycles in their recent declines due to reflexivity of those companies, so the category is considered by many to be toxic right now and VC funding in many sectors is drying up. Moreover, markets in general have a ways more to fall as rates rise, and rates could continue rising if inflation, mainly a supply side issue, is not stopped. Selectivity will be key in picking growth names, and you should pick some because it’s in times like these that companies with unbelievable secular opportunities and terminal values become inordinately cheap.

How Has Growth Performed in 2022?

The story of value versus growth is an old one, but in the last decade or so, the battle has been very one sided with growth almost always outperforming the value category. FANG stocks and the ascendancy of other tech names like Tesla (TSLA) have all become the most dominant stocks in market indices, where 30 years ago the most valuable companies were all banks and oil companies, most of them Japanese, a now quite marginal economy. Since 2020, the growth category remained a major winner as WFH and other pandemic related digitisation benefited the swathe of growth and tech names on the markets, and also more incentive for new tech listings that capitalised on market fervor. Comparing the Vanguard Growth ETF (VUG) to the Vanguard Value ETF (VTV) we see the following performance.

vug vs vtv

VUG vs VTV 2020-Present (Koyfin)

However, from about mid 2021 when inflation started getting persistent and high, things really reversed. Value names that benefited from the commodity and goods boom meant a reversal in a longstanding plod of value stocks rocketing many to new heights. In particular, the Ukraine war starting in early 2022 led to a change in narrative that has opened up the market’s mind to oil and other fossil fuel investments again. Meanwhile, the calming of demand surges for digital companies meant a reversal in many major growth names, putting value on the top podium over the last 12 months.

VUG VTV inflation

VUG vs VTV last since April 2021 (Koyfin)

How Will the Market Perform in the Rest of 2022?

The most recent developments have been higher than previously expected rate hikes instituted by the Fed and followed by lots of major monetary authorities across the world. This has caused a relative indiscriminate fall in stocks, including both value and growth, even though growth had already taken some lumps this year. The issue is that the markets could still fall a lot more. The 10-Y treasury yield is now above 3% but the earnings yield for the S&P is at 5%. This implies a 2% risk premium for taking on S&P exposures. This is a very small risk premium for taking on stock exposures that are substantially levered to growth expectations when recession is looming, and otherwise to expectations for even further increases to the interest rate which will soon shrink the premium further. Moreover, supply chain issues and inflation, if rate increases weren’t to work, still renders equity exposures meaningfully uncertain compared to bond flows, especially when paid in a powerful USD. The markets could fall a lot more.

Picking Growth Stocks

Indeed, the market itself is at risk from the FANG names and other megacap tech stocks that determine much of the indices movements. Those stocks, which have been by definition major beneficiaries of the recent tech spending up-cycle, are probably not the best picks right now. However, there are plenty of tech names out there that are less favoured by the markets and have been even further hit by general market movements to the downside, still offering promising secular stories. When markets are potentially very large for some tech names the opportunity to buy at a discount could double the returns of those stocks by the end of your holding period compared to if you had bought them half a year ago.

However, there is one important caveat to the buying the dip mentality in the case of growth stocks which is that they should be self-financing, otherwise in a down-market your investments will be subject to the mercy of reflexivity, a concept popularised by everyone’s favourite person George Soros. Very simply, companies that are not self-financing will be likely to rely on their own stock for financing, and a down-market means more severe dilution which comes at the expense of current equity holders. Therefore, with the incentive to sell, the price deteriorates further and creates a stronger incentive to continue selling. This is what happened with many companies after they de-SPACed, where a venture profile and lacking SPAC appetite actually damaged fundamentals of the company. Reflexivity is what makes growth stocks in general more vulnerable than value, and this force is exceptionally powerful and has to be taken very seriously in a recession.

Bottom Line – Consider LIVN

While we discussed generally what we’re looking for, a growth pick that fits the bill well that you might want to consider is LivaNova (LIVN). Their big draw are their neuromodulation technologies that stimulate the Vagus nerve to deal with conditions such as epilepsy, sleep apnea and most promisingly difficult-to-treat depression. The reason why the stock is compelling is because of the high likelihood of success of the DTD product, which is still trialing for insurance coverage. The reason it’s likely to succeed is that from trials 15 years ago that failed, thousands of people have been carrying their implants in them, and while the trial failed within the required 6-month period, the years of evidence accumulated from this cohort showed that improvement already started after nine months, and that lives have been markedly improved. The peculiarity of having thousands of implants in patients from a failed trial more than a decade ago creates an asymmetric opportunity here that investors should consider while betting on the large DTD market.

Regardless of what you pick, remember to keep a long-term view. If you think you are investing into a generational opportunity in terms of the addressed market, then buying at some point now with these discounts should create opportunities. A strong secular picture elevates multiples more than anything due to the high value from a growing perpetuity valuation. While you might not get the timing just right, if the opportunity in their markets exist, whenever investors generally realise it your returns will be all the higher for having bought in a panicked market.

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