What a year 1999 was for growth investors. After a cyclical rally early in the year, investors turne...
What a year 1999 was for growth investors. After a cyclical rally early in the year, investors turned their attentions to the impact of the technological revolution and the prices of growth shares soared.
As we move into the twenty-first century the question everyone is asking is whether the good times for growth can last?
A key concern is whether investors are being too optimistic about inflation. We are inflation bulls because the structural disinflation caused by deregulation, restructuring and e-commerce is continuing. We are aware that cyclical factors, notably oil prices, are likely to cause an upturn in inflation but believe that pre-emptive action by central banks will do enough to ensure that inflationary pressures are controlled.
Certainly, the current level of capacity utilisation has not been associated historically with a significant cyclical upturn in core inflation. Moreover, a glance at the money markets tells us that increases in interest rates of about 1% are already expected in the US and Europe this year. This gives some protection to markets.
Looking at traditional valuation measures, there is every reason to be nervous about markets, and the US equity market in particular. The US bond/equity earnings yield ratio has headed through 2 times, and well beyond its traditional range of between 1 times and 1.4 times.
It is extremely dangerous to say that it is different this time but we have to take account of significant differences that make simple historical comparisons misleading. Firstly, the US stock market has diverged from the real economy. Technology, for example, is 8% of US GDP but represents 35% of the US stock market. That is why S&P 500 earnings have been growing three times faster than US nominal GDP.
Secondly, today's companies are more knowledge-based, and need less physical capital. Accounting methods are ill-suited for modern corporations. R&D is often the main asset for knowledge-based firms. But it is expensed in year one rather than capitalised.
What is a pharmaceutical or software company other than its cumulative R&D? L Nakumara of the Philadelphia Fed points out that the expected price/earnings ratio for non-financial corporations after tax profits in the S&P in 2000 drops to 17 times if one capitalises R&D and depreciates it over six years.
The case for tomorrow's companies remains open. What is more clear-cut is the danger of investing in yesterday's industries. Ironically, many value stocks may prove to be high risk on anything other than a very short-term basis as a result of changing patterns of distribution.
It is interesting that, despite a contested bid for NatWest, the banking sector underperformed the market in the final quarter of 1999.
We will continue to look for those growth companies which are able to innovate, have global potential and the ability to outstrip the market's assumption of its fade rate.
These companies are rare but as we have seen with Sage and ARM, the prize for success is rich. The danger for investors is to make the mistake of buying proxies for the genuinely good companies that exist and are being created. It is no surprise that corporate financiers are already setting the traps and using the deadly cocktail of a limited free float and the over-enthusiastic private investor to ramp share prices of shell companies. So, be careful, because although the winners will do well, there will be a large number of losers.
Charles Curtis is fund manager at Deutsche Asset Management
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