All markets, especially the stock investment market, have collapsed this year. But the collapse of investment in growth stocks is especially notable: Valuations of fast-growing investor darlings have been wiped out as the Fed embarks on its most aggressive rate-hiking campaign in decades. But if all these rate hikes push the US economy into a recession, it could actually work out very well for growth stocks, if we know how to identify which ones…
Why investing in growth stocks is a good recession hedge?
The relative attractiveness of investing in growth stocks improves during a recession, when most other companies see their profits decline or stagnate. Put another way, when growth is poor, investors flock to the few companies that can still continue to generate profits - in other words, growth stocks.
Investing in growth stocks has been a good hedge in difficult times. Source: JP Morgan Asset Management
When the U.S. economy enters a recession, the Federal Reserve typically pauses or even reverses some of its previous rate hikes. That benefits investing in growth stocks, whose valuations are more sensitive to changes in interest rates.
During the 80s, the FED lowered rates to save the economy. Source: Marketwatch
In the current scenario, a worst-case scenario would see the Fed halt rate hikes, removing the valuation hurdles facing growth stock investing this year. In the best-case scenario, rates would fall, generating a huge revaluation for investment in growth stocks.
So, what criteria do we follow to consider an investment in growth stocks?
We are not officially in a recession, and there is no need to rush and start shopping now. We can begin to identify attractive growth stocks to add to our watchlist. Basically, companies that are more likely to generate outperformance if there is a recession. We suggest you analyze these three criteria:
1. The company is profitable
Unprofitable companies with high revenue growth tend to see their losses soar during a recession. That forces many of them to sell new shares at lower prices or accumulate large amounts of debt, both of which affect shareholders.
Types of investment in growth stocks. Source: WallStreetMojo
For this reason, it is best to focus only on companies that are truly profitable, with higher profit margins and fast growing earnings per share (EPS). These companies are more resilient during recessions. We can think of them as “defensive growth” actions.
2. The stock is attractively priced
While you want to make an investment in stocks that are seeing growth in their EPS, you are not going to want to overpay for that growth. Investing in growth stocks that look expensive can get us into trouble when their results don't meet investors' expectations, as happened recently with Netflix.
Investment in stocks like Netflix has suffered during 2022. Source: Bloomberg
And let's face it, you're more likely to see slow growth (or decline) during a recession. So when we look for growth stocks, we need to look for those that are attractively priced. One way to do this is to filter stocks with PEG ratios low (P/E divided by earnings growth ratio). The online investment tool FINVIZ can you help us. It allows us to evaluate many criteria about investing in stocks, including the PEG.
Stocks with low PEG ratios. Source: Finviz
3. The company can generate profits during a recession
Remember, when broader economic growth is weak (or negative), investors flock to the few companies that can still grow their profits. Therefore, your job is to find companies that can still grow their profits during a recession.
Economic market cycles. Source: Ana Trenza
A company could, for example, benefit from a broader trend that is not affected by a recession, such as a wind or solar company on a site with ambitious renewable goals. Or a company could have strong pricing power on products that people need, even in difficult times, such as a biotechnology company with life-saving products in an industry with few competitors.
How do we take advantage of this stock investment opportunity?
Companies like Vestas Wind Systems (VWS), CropEnergies (CE2) or First Solar (FSLR) are the best positioned in this sector. If, on the other hand, we want to diversify our investment in stocks in this sector, we can gain exposure by investing in the iShares Global Clean Energy (ICLN).
Remember, economic conditions can change quickly. Therefore, preparing now will put us in a strong position, ready to adjust our portfolios when the time comes again for stock investing.