Growth Stock Unwind Severs Link Between Balance Sheets And ‘Quality’

You’ve heard it time and again by now: Year after year of outperformance and market leadership lulled investors into a false sense of security vis-à-vis US growth stocks.

Importantly (and I can’t emphasize this enough), it’s not just that market participants came to view mega-cap tech shares as “safe” in the kind of general sense that the large, blue chip companies which permeate our daily lives are typically good investments. Rather, an overlapping set of self-feeing dynamics created a scenario wherein a handful of US tech companies and growth stocks became ostensibly synonymous with multiple investment styles simultaneously. That, in turn, meant that the same stocks were included in a variety of factor-based products, which meant they received even more “passive” inflows than they’d have already received as the most heavily-weighted names in benchmark indexes. Those inflows swelled their market caps even further, handing them an even larger share of passive (without the scare quotes this time) flows and so on, in a never-ending loop.

So, mega-cap US tech shares were i) utilities conceptually, ii) large-caps by definition, iii) growth stocks by definition, iv) low-vol stocks by virtue of never selling off, v) strong balance sheet stocks because they became synonymous with everyday life and commanded a larger and larger share of aggregate revenues and profits, vi) quality stocks because when you have a strong balance sheet and you’re a blue chip, you’re “quality”, vii) momentum stocks due to their inexorable ascent, and on and on.

That factor overlap, combined with hedge fund crowding and a favorable macro backdrop, manifested in what Howard Marks famously dubbed a perpetual motion machine. The only thing capable of short circuiting that machine was an epochal macro shift, which we now have.

I bring this up again not just because it’s part and parcel of nearly every discussion about the outlook for equities, but because many market participants likely don’t appreciate how ubiquitous the unwind of the long-duration trade (the short circuiting of the perpetual motion machine) really is in these discussions.

That unrecognized ubiquity is the mirror image of the trade itself. Investors (even large investors) didn’t fully appreciate the extent to which they were participating in a giant leveraged long-duration bet.

With that in mind, I’ll give you yet another example. Currently, investors are pondering the best way to position for a potential US recession or, at the least, a slowdown. In such an environment, you might be inclined to favor strong balance sheets over weak balance sheets. Interest coverage ratios are near record highs and elevated margins likely mean that, for the largest US corporates, profits will easily suffice to cover interest expenses, but intuitively, you want a strong balance sheet in a downturn.

But the demise of the perpetual motion machine muddies the waters. “Despite financial conditions tightening and recession fears, Weak Balance Sheet stocks have actually outperformed Strong Balance Sheet stocks YTD,” Goldman’s David Kostin noted.

The figure (below) shows indexed relative performance for strong balance sheet stocks. Note the massive outperformance that accompanied the pandemic, the subsequent fade (which started with the election/vaccine value rally and continued into Q1 2021’s bond selloff), the resumption of outperformance into year-end 2021 and then the renewed underperformance referenced by Kostin in 2022.

Investors, Goldman said, are naturally curious as to whether this year’s underperformance “presents an opportunity to buy Strong Balance Sheet stocks” ahead a prospective economic slowdown.

Goldman’s one-word answer: “No.”

“The Strong vs. Weak Balance Sheet trade is trading in lockstep with Growth vs. Value and interest rates,” Kostin went on to say, adding that “the sharp rise in real rates has precipitated meaningful underperformance for growth shares.” “In today’s environment,” he remarked, “many of the strongest balance sheet stocks are also growth stocks.”

And there you have it. The previously virtuous dynamic wherein perennial growth-stock winners became synonymous with multiple investment styles simultaneously, is now making it difficult to determine how best to position for an economic slowdown.

The figure (below), shows the correlation between strong versus weak balance sheets and defensives versus cyclicals has collapsed into negative territory.

Compared to the 2002-2019 average, earnings stability and net margins are more important in explaining forward multiples compared to balance sheet strength, the importance of which has diminished materially.

Goldman’s message: If you’re looking to own “quality” ahead of a potential economic downturn, own stable growth stocks. The bank’s basket of such shares includes just one of the FAAMG cohort: Alphabet. Goldman’s strong balance sheet basket, by contrast, includes Alphabet, Meta, Netflix, Nvidia, Adobe and Tesla.

“Many investors have drawn comparisons between elements of today’s market and the Tech Bubble experience, including the underperformance of growth stocks,” Kostin said. “Given the overlap between Strong Balance Sheet and growth stocks today, the balance sheet trade will likely continue to reflect Growth vs. Value and interest rate risk rather than represent an expression of ‘quality’ attributes.”