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If You Want Growth, Stick With Quality Stocks. How to Find Them. -- Barrons.com

Barron's · 01/06/2023 10:47
By Jacob Sonenshine

The path to profits in growth stocks has dimmed. Soaring interest rates have sent investors to the comforts of value. Last year, the Russell 1000 Growth Index fell by 30% versus a 10% decline in the Russell 1000 Value Index, one of the widest performance gaps on record.

The highest interest rates in 15 years aren't about to vanish, keeping up the pressure. Higher rates punish multiples for growth stocks, partly because they make "risk free" rates of return more attractive in Treasuries and other less-risky assets. Nowhere does that sting more than in shares of unprofitable companies expected to generate earnings far in the future.

But growth fund managers aren't giving up, and investors shouldn't, either. The selloff has made valuations more palatable, and plenty of companies are lifting earnings above the market average -- expected at about 8% in 2023 for the S&P 500 index. With the macro climate and market shifting, so too should investors. Stick with higher-quality companies and their stocks, while avoiding the more-speculative, unprofitable names.

"Companies, if they don't produce profits, are being pushed off in the asset management community because investors are demanding profits now," says Chris Hyzy, chief investment officer of Merrill and Bank of America Private Bank.

Quality comes in many flavors, but core ingredients include sturdy balance sheets, positive cash flows from operations, and a healthy outlook for revenue. Investors are sharply penalizing stocks for even the slightest miss to revenue or profit forecasts. But high multiples shouldn't be a deal breaker; some companies can justify high valuations with similarly strong earnings rates, measured by price/earnings-to-growth, or PEG, ratios.

Companies without those attributes are in a bind; if they're unprofitable and can't fund their operations or growth organically, they may need to tap the capital markets for financing. That has become costlier amid steeper rates and tighter financial conditions. Investors are demanding higher returns on debt and equity. That will remain a risk to companies having trouble moving toward profitability.

"You'll need to cast a wider net to find the true quality growth stocks of the next decade," says Dave Donabedian, chief investment officer of CIBC Private Wealth Management.

Barnaby Wilson, a portfolio manager and analyst at Lazard Asset Management, looks for businesses with "high barriers to competition" and "high level of financial productivity." He likes companies that are "capital light," meaning they don't need much external financing or plan large capital expenditure. He also likes companies generating cash flows in the midteen percentages on their capital investments.

What fits the bill? Top holdings in Lazard International Quality Growth Portfolio (ticker: ICMPX), a fund that he runs, include semiconductor-equipment maker ASML Holding (ASML), LVMH Moët Hennessy (MC.France), Unilever (UL), and Dollarama (DOL.Canada). All have plenty of cash to fund their operations, and revenue growth is expected to remain strong.

To find other names, Barron's screened for stocks with several quality attributes. We looked for S&P 500 companies expected to produce 10% annualized earnings growth over the next three years, more cash than debt on their balance sheets, and PEG ratios below the market average of two, implying some valuation support.

Stocks that passed include solar-equipment maker SolarEdge Technologies (SEDG), cloud-networking-gear maker Arista Networks (ANET), and software giant Microsoft (MSFT).

SolarEdge says it's seeing growth across all of its markets as government incentives for renewable energy ramp up in the U.S. and abroad. While it's facing shortages of components, the company expects "double-digit significant growth" in 2023 and 2024. Wall Street sees earnings rising 85% in 2023. The stock trades at a steep 35 times profits, but its PEG ratio is just 0.8, based on earnings forecasts over the next three years.

Arista is a big player in cloud-networking gear and integrated software platforms. Its growth, while slowing, still looks compelling with sales expected to be up 24% this year and 11% in 2024. Shares trade at 20 times estimated 2023 earnings, above the market average, but look cheap with a PEG ratio of 1.5, based on annualized three-year estimated earnings.

Microsoft has been slammed by the selloff in megacap tech, but it continues to enjoy strong demand in its cloud business. That should help fuel sales gains of 10% in 2023 and 14% in 2024, according to consensus estimates. With 15% compounded earnings growth expected in the next three years, the stock's PEG is just 1.4 times.

Another name that passed our screen is Humana (HUM). The health insurer is racking up sales as more Americans head to retirement and buy its Medicare Advantage plans. Humana is also curbing operating costs, which may lift operating margins. Analysts expect earnings to compound at a 13% rate, giving Humana a PEG ratio of 1.4 times.

The macro climate isn't likely to be favorable for growth this year. That may make quality even more valuable.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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January 06, 2023 10:47 ET (15:47 GMT)

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