Growth addiction and tightening cycles: learning from the dot.com bubble

An additional similarity with the “dot-com bubble”: enthusiasm for growth whatever companies’ financial quality

On the back of the Asian crisis and the collapse in oil prices, a scarcity of growth stories in 1998-99 pushed investors into internet and telecom companies (figure 2) for which the outlook was promising,  driven by the rise of computer ownership and the popularisation of internet usage. The year 2000 was a   record year in terms of IPOs, with over 3000 deals recorded versus 1500 on average per year in the previous decade. Dot.com companies, internet infrastructure stocks and telecommunication companies, engaged in bidding wars for 3G licenses, led the IPO and capital raise frenzy.

Figure 2: Split of top 40% growth companies by sectors

Source:LOIM

Most of these sought-after growth companies were loss-making and heavily dependent on capital markets to fund their growth either through capital increase and/or debt issuances. Consequently, in 1999-2000, companies that were the most dependent on capital markets for their funding were performing extremely well. This outperformance represents a very unusual pattern from an historical perspective (figure 3). Such companies tend to underperform given equity dilution and/or accumulation of debt over time.

While not as extreme as in 1999-2000, we have also seen an outperformance of companies that are highly reliant on external financing since December 2019 (figure 3).

The “Great Lockdown” also created growth scarcity during the crisis due to the physical stoppage of economic activity. Investors’ attention turned towards pockets of growth themes, mostly around digitalisation, e-economy or working from home (WFH) (figure 2). Given the extremely accommodative monetary conditions (liquidity and low interest rates), growth companies’ valuation skyrocketed. The number of IPOs is now back to an all-time high of 3200 in  2021, while the year is not yet over, accompanied by a special purpose acquisition company (SPAC) frenzy in the early part of the year. Like in 1999-2000, we have also noticed that companies in most need of financing, to support their growth outlook, are back in favour (figure 3).

Figure 3: Backtest of dependency to capital market (Q1 lowest dependency / Q5 highest)

Source: LOIM. For illustrative purposes only.

Tightening monetary policy could drive a growth correction

While multiple dynamics contributed to bursting the 1999-2000 bubble, the rapid tightening of the monetary policy was a noticeable event.

In early part of 2000, the US Federal Reserve, under Alan Greenspan, became increasingly worried about the  inflationary pressure that could arise from “increases in demand that will continue to exceed the growth in potential supply, even after taking account of the remarkable rise in productivity growth” (driven by the technology boom). In parallel, the pool of available workers willing to take jobs was decreasing rapidly². Core CPI was indeed moving up from the 1999 lows of sub-2% back to around 3%, while headline inflation moved from approximately 1.5% to almost 4%.

Eventually, the federal funds effective rate moved from 4.6% in early 1999 to 6.5% in the summer of    2000 (with US 10 year Treasuries, at constant maturity, reaching approximately 6%). This rapid rise in short term rates led to a yield curve inversion (where short-term rates are higher than  longer-term rates). Funding for dot.com business models dried up rapidly. As they were not able to get any funding to support their growth promises, expectations collapsed, driving down market valuations (figure 4).

This dynamic triggered the “revenge” of the old economy. From March 2000 to April 2001, the Nasdaq index  fell almost 60%, while Dow Jones Index went up 8%.

Figure 4: Perf. of growth and highly dependent companies to external funding

Source: LOIM 

2  FOMC statements from October 1999 to March 2000

The current debate on inflation and central banks policies seems to resonate with 2000.

Commodity price surges, supply disruptions, freight constraints, shelter costs and wage increases are accumulating one after the other. Contagion to core CPI is increasingly visible and fears of stickiness and contagion to wages are making the headlines. If central banks were to accelerate their normalisation efforts, or even tighten monetary conditions quicker than expected (especially if inflation is transitory), market participants would likely shift away from these unfunded growth companies and focus their attention back on higher quality businesses. In our view, a drastic change from the current unique negative real rates environment (-3-4%) to a neutral or, worse, positive one (with interest rates higher than inflation) would create such a shift in market positioning.

Such a scenario could occur if central banks tighten too quickly, while inflationary pressures eventually prove to be “just” a one-off without a spiraling effect and that by the second half of 2022 we end up with a much lower than expected inflationary regime and slower growth. This would be a “policy mistake” leading to a funding tightening.

For the time being (as illustrated in figures 5 & 6), the poor quality growth upsurge has not been as rapid and extreme as in 1999-2000 but is holding up and has lasted longer, so far.

Figure 5 & 6

Source: LOIM

Adopting a barbell approach

Looking ahead, we strongly believe that low-quality-high-growth companies are the most exposed to a stronger-than-expected tightening cycle. However, we also recognise that timing and speed of the tightening cycle is still open to debate. We could remain longer than expected in a world where capital is a commodity with negative cost, favouring high growth companies.

Consequently, our portfolios need to be structured in a way where we still stand to benefit from growth exposure, while being prepared for a tightening cycle. At the same time, we believe that the current focus on growth has left behind many attractive opportunities. Portfolio positioning should now reflect an increased focus on companies that can self-fund their growth, as well as on valuation and quality.

In 2000-2001, the “dot.com” bubble occurred at the expense of companies that were cheap for their level of financial quality. We refer to these as DEER³ companies. Their price-to-book or Ev-to-capital employed is too low compared to their high level of capital efficiency (ROE, ROCE), they exhibit attractive maintenance-free cash flow generation, and they have a low dependence on external financing. Eventually, DEER companies started  to outperform when interest rates peaked in March 2000, well into September 2000 when the bubble burst , and into the subsequent recession of early 2001. Today, the underperformance of DEER companies versus growth companies is as pronounced as it was in 2000-2001. These companies are currently at attractive levels in case monetary policies tightening accelerates.

Figures 7 & 8

Source: LOIM

In addition to capturing these DEER companies, a shift towards more self-funded growth stories would allow investors to continue to participate  in the growth-party while limiting – to some extent – the downside risk. As illustrated in figure 9 and 10, self-funded growth companies tend to follow the performance of the less funded ones. Although self-funded companies underperformed in late 1999, they eventually held up much better during the tightening cycle of 2000 than the less funded ones. Well-funded growth companies proved to be more resilient during the 2001 recession and even recovered earlier in late 2001. Focusing on the dependency of growth companies to external funding is therefore increasingly essential as the probability of entering a tightening cycle is on the rise.

We have adopted this approach across our equity range. Our strategies (regional/thematic) focus on companies that can both grow above indices with more resilient funding profile, and structurally generate attractive excess economic returns overtime. For example, our global strategies (Natural Capital, Climate Transition, World Brands, Golden Age, FinTech,) or regional strategies (Asia High Conviction, Europe and Swiss Small & Mid Caps, Emerging High Conviction) all share these characteristics of higher growth and higher quality than reference indices.

Figures 9 &10

Source: LOIM

3   DEER = Discounted Excess Economic Returns (LOIM’s definition of attractively priced quality companies)