Growth opportunities are growing scarcer. Thematic investing can help alleviate that problem

• A low interest rate environment disproportionately benefits higher growth firms in terms of their valuations
• Growth assets increasingly scarce and expensive – highlighting the need for a strategy or framework designed to sniff out growth opportunities
• As its name suggests, Allianz Thematica Cl AT Acc USD invests thematically across the globe in its search for growth, ensuring investors are well diversified across the various spectrum of growth

Low interest rates is a global phenomenon. Most G10 countries have implemented negative or zero interest rate policies (NIRP/ZIRP). Developing nations are also not far behind. The only thing that is on central banks’ minds right now is combating deflation – a reality they believe must not come to pass. Their immediate course of action was to flood the monetary system with liquidity, in tandem with the fiscal measures implemented by governments globally. The sudden change in monetary/liquidity condition – from tight to loose – increase the likelihood right tail moves (a positive outlier event) to occur, especially since it causes market participants to reprice assets relative to their growth and inflation outlook.

Growth is the only game in town

Why’s that so? First we have to understand how companies are valued. Essentially, a company’s value comes from stream of future cash flows that the firm can theoretically generate. Most valuation models used are highly sensitive to the terminal (the end of a forecast period) value of a company. Terminal values are mostly affected by either changes in growth assumptions or discount rates.

Growth companies are often assumed to have higher terminal growth rates. As such, they are perceived to be worth more, since they are expected to grow at faster rates than the broad economy. The converse is true for stable and mature businesses – they are worth less (and hence they are known as “value” companies) since their growth rates are unlikely to be significantly higher than the broad economy. When central banks cut interest rates, it has the domino effect of lowering the discount rates for equities, and thus inflating their asset values. However, changes in discount rates benefits growth-centric companies disproportionately.

Perhaps this concept is best understood with a hypothetical example. In this hypothetical scenario, let’s value a typical growth and value company with the same future cash flows and discount rates. The only difference between the two are their growth rates. Growth rates for the hypothetical growth and value firms are assumed to be at 10% and 5% over ten years, and their terminal growth rates at 5% and 2% respectively. As the discount rates decrease, the chart below shows that lower rates benefit growth companies more.

Chart 1: Visual relationship of how changes in the discount rates affect the net present value of cash flows for growth and value companies

And given how the largest components in equity indices these days are dominated by large and mega cap growth companies (e.g. Tencent, Alibaba, Google, Facebook, Apple, Microsoft, Netflix, Amazon, just to name a few), it could serve to explain why market-cap weighted equity indices have rebounded so fast and so quickly over the past few months. These companies are global oligopolies with little to no competition. Plus, they all have wide competitive moats. Such companies are more likely to disrupt other industries, and grow larger resultantly, than to be disrupted. Therefore, the market is likely expecting these companies to continue to grow relatively faster for the foreseeable future. Lower discount rates as a result of global monetary expansion, are making these companies more valuable given that growth opportunities are increasingly scarce.

Generally speaking, a low growth environment begets low interest rates and low earnings growth. In the minds of market participants, the solution to avoiding the prospects of receiving low investment returns, as a result of low earnings growth, is to seek shelter in faster growing companies. Using lower rates to discount cash flows tend to result in higher value for companies – those with greater terminal growth trajectories will benefit more than those with lower growth. Another perspective is to view high growth firms as ‘long duration’ plays, since a large portion of the firms’ present value of cash flows are longer dated and thus highly sensitive to changes in interest rates.

Is value investing dead?

Large institutional investors like Bridgewater are increasingly moving away from low yielding safe haven assets into alternative investments, or into equities with long duration characteristics. Think about it. In a world where both the monetary and fiscal authorities are backstopping both the real and financial economy, who would miss out on receiving an earnings yield of 4% (assuming a forward P/E of 25.0X) with potential for earnings growth, as opposed to investing in a government bond or investment grade credit yielding 2% or less? Surely some market participants would dip their toes in favour of the higher yielding asset.

Chart 2: Mean reversion between growth and value may not happen any time soon – there is no universal law dictating that

Given the rich valuations we see in the market today, evidently there is a short supply of growth investments out there. Today, it’s not difficult to find companies valued at 10.0X Price to Sales or 40.0X Price to Earnings. These are valuation metrics are growing increasingly common. While the relative of performance of growth companies are likely to outpace that of value companies in the current macro environment, we do not think investors should go all-in on any growth stock they may find.

For one, any asset with high valuations are always at greater risk of sharp and large corrections, as momentum traders head for the exits in large droves at any first sign of danger. The recent 3-day meltdown in tech-related stocks last week are good examples of the fickle nature of growth stocks. We want to avoid drawdowns associated such sell offs as best as we can. The best way, we believe, while staying invested is to diversify across the entire growth spectrum.

Diversifying through a basket of thematic ideas

The types of growth opportunities most retail investors are aware of, are mostly concentrated within a handful of market segments. In reality, however, growth ideas are aplenty. Rather than investing solely in a couple of ideas (for instance, semiconductors and digital economy), investors may want to consider exposing your portfolios to a more diverse range of growth opportunities. The world is brimming with innovation and no market or sector has a monopoly on growth. Here on our platform, we believe Allianz Thematica Cl AT Acc USD is one strategy that can let you have that diversified exposure to growth. Essentially, their investment objective is to break down the megatrends they observe into investable themes and topics. 

Allianz Thematica Cl AT Acc USD’s investment team seeks to invest in 5 to 7 fast growing themes (at any one time) spanning across various sectors and markets globally. Some examples of themes they may invest into include Water & Waste, Health Tech, Education, Future Factory, Digital Life, Pet Economy, and Next Generation Technology. Within each theme, there could be sub-themes the investment team may identify. For example, within the Digital Life theme, it could be further broken down into topics like eSports, Digital Payments, and Remote Work. The type of themes and topics the fund can invest into are only limited by the investment team’s imagination, and the number of companies available within each thematic universe.

Chart 3: Fund portfolio allocation as at June 2020

In every theme, investors can expect a basket of 15 to 30 stocks that best represent the upside potential available or sensitivity to a particular theme. As a whole, the portfolio would be very well diversified with anywhere from 150 to 200 equity securities under its belt. In our opinion, company-specific risks would be largely nullified, which means macro and industry factors are more likely to drive overall returns over the long term.

As an ongoing basis, the investment team would review on the investment attractiveness of each theme. Past themes that they have previously into and have since excluded from their portfolios, were Safety & Security, China Impact, Future Factory, Car of the Future, and Health Lifestyle. According to the manager, the fund is likely to replace or remove 1 to 3 themes from its portfolio every year to ensure investment opportunities remain attractive and evergreen, since they find that not all themes would perform well at a single point in time.

Allianz Thematica Cl AT Acc USD’s strategy has been able to shine brightly in a world where growth-centric investments are favoured. Whether on a year-to-date, one-year, or three-year basis, the fund stands head and shoulders above its peers as well as its benchmark in terms of overall returns. However, Allianz Thematica Cl AT Acc USD is also more volatile; it plunged the most during the March 2020 drawdown even amongst other growth-centric global equity funds on the platform. However, investment return is often commensurate with the amount of risk taken – therefore embracing volatility should always part and parcel of generating higher returns for your portfolios. It would be no different with Allianz Thematica Cl AT Acc USD.

Chart 4: Fund performance versus MSCI AC World Index