Domestic Equity—Growth | September 2013
Investors have been warming up to rapidly growing companiesBy Thomas Ognar, CFA; Joseph Eberhardy, CFA, CPA; and Bruce Olson, CFA—Portfolio Managers, Wells Fargo Advantage Premier Large Company Growth Fund
In a market environment characterized by low interest rates and economic uncertainty, many investors over the past two years turned to the perceived safety of income-producing investments with less regard for longer-term growth opportunities. As investor demand for yield increased, we believe that many investors paid a higher premium for stocks that offered relatively high dividend yields but provided low earnings growth potential. In contrast, we believe the valuations for faster-growing companies became quite compelling, particularly when compared with the valuations for higher-dividend-yielding equities. However, in recent months, investors have exhibited signs of refocusing on the upside potential of faster-growing companies.
As illustrated in Chart 1, investor demand for stability and income led to strong performance in early 2013 from stocks with significant dividend yields. However, a notable increase in the 10-year U.S. Treasury yield, beginning in early May, appeared to reduce investor demand for income-generating equities. As a result, market leadership shifted substantially to companies with high growth prospects.
Chart 2 illustrates the valuation relationship between higher-dividend-yielding stocks and high-growth stocks within the S&P 500 Index since 2003. Over the past few years, higher-dividend-yielding stocks have been trading at elevated levels relative to higher-growth stocks. We believe that relative valuations for faster-growing companies continue to look attractive despite the significant outperformance by these companies in recent months.
From early 2011 through early 2013, investors appeared aggressive at times in their pursuit of higher-dividend-yielding opportunities. This trend was particularly evident as longer-term U.S. Treasury yields declined, partly due to the Federal Reserve’s (Fed’s) quantitative easing measures. From early February 2011 through the end of April 2013, the yield on the 10-year U.S. Treasury note significantly declined from approximately 3.7% to 1.7%. Over this period, valuations for higher-dividend-yielding stocks were generally rising relative to high-growth stocks and the broad equity market. Beginning in early May, signals that the Fed’s bond-purchasing program could be slowing down in late 2013 led to a significant increase in longer-term bond yields, which reduced the demand for income-generating equities. Consequently, rapidly growing companies benefited from increased investor interest in growth potential, particularly in an environment in which robust growth is relatively scarce.
In our opinion, the current low corporate earnings growth environment should lead to premium valuations for robust and sustainable growth opportunities. As a result, we believe that it will be increasingly important to determine which companies are best capable of rewarding shareholders with sustainable revenue and earnings growth rather than simply paying out dividends. We have identified several companies that we believe have strong, secular tailwinds that may support sustainable organic growth under a variety of economic conditions. However, even with these solid growth prospects, many of these secular growth companies appear underappreciated and are still trading at compelling valuations relative to their long-term growth rates. This dynamic, in our opinion, presents a favorable valuation-to-growth profile for long-term investment.
Concluding observationsWe believe that investors should consider multiple factors when making equity investment decisions rather than just taking a singular view of risk-to-reward in the context of dividend yields. An analysis of earnings estimates and valuations reveals a unique opportunity to invest in companies with robust and sustainable growth potential that may be underappreciated by other investors. Our analysis identifies strong growth companies that are effectively reinvesting cash flow in an effort to expand their businesses and successfully grow their revenues and earnings. We believe that companies that are consistently executing in this regard are likely to be rewarded with higher share prices over the long term through a combination of both solid earnings growth and potentially higher valuations.
Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Smaller-company stocks tend to be more volatile and less liquid than those of larger companies. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk. Consult the fund’s prospectus for additional information on these and other risks.