A range of catalysts

There are usually a range of catalysts fuelling the rise of growth companies. These can include supplying an essential or exciting component in a fast growing industry such as AI, having a dominant market share in a particular field or being the first to market with a new product in a specialised field like pharmaceuticals (also known as ‘first mover advantage’). Macroeconomic events can also spur supernormal growth for stocks, or even sectors. If output of a particular commodity is restricted in some areas, for example, this benefits those companies still able to supply the market. Many successful companies enjoy supernormal growth, often for much longer than a year, during their formative years, before slowing as they and their market mature.

Valuing these stocks

Supernormal growth is not sustainable over the long term. This can be as the more exciting prospects encourage competition, which in turn will drive down selling prices and ultimately weaken the growth profile for the sector and related stocks. It is also difficult to calculate a fair value price for supernormal growth stocks because they have two growth phases which need to be valued – the first being supernormal, and the second, normalised. This means that a multi-stage dividend discount model (DDM) is needed to calculate the present value of any dividends generated during the earlier high growth period, as well as those generated during the later lower growth period. This contrasts with a company with consistent normalised growth. Here a simpler DDM is used to reflect a more stable earnings and market outlook.

Technology’s the thing

While supernormal growth stocks can deliver exponential returns, much will depend on identifying the right stocks and themes. For the past year, the positive performance of the S&P 500 index has been due to the very strong returns a handful of companies. These are the Magnificent Seven technology linked stocks – Apple, Amazon, Microsoft, Google, Nvidia, Meta and Tesla. The last of these might now be considered ex-growth. With a share price of just over $1 in 2010, it took a decade for Tesla’s potential to get noticed by the market. It was only in 2020 that the share price took off, starting that year at $29, but finishing it at $235 in December. The stock subsequently peaked at $407 in November 2021. Over the five years between 2019 and 2023, Tesla’s growth in revenue, operating margins and operating profits was exponential. Automotive revenues of $20bn in 2019 increased 396% to $82.4bn by 2023, while its negative operating margin of -0.3% rose to 17% in 2022 before finishing at 9.2% in 2023. In January 2024 Tesla was the weakest performer in the S&P 500, slipping 24% and it remains a laggard. A major reason for this was the company’s fourth quarter update on its expected “notably lower” 2024 sales growth, some signs of which were apparent at the end of 2023. Reasons for this included the intensifying competition from Chinese EV manufacturers, as well as changing market dynamics and consumer preferences after years of rapid growth. Price cuts and higher research and development costs have also weighed on sentiment.

In contrast, Nvidia remains in supernormal growth territory. It has risen from $150 at the beginning of 2023 to >$700 by February 2024.  It is now one of the five most valuable companies in the world by market capitalisation, larger than the whole of the Chinese stock market. The market’s excitement rests on Nvidia’s control of the market for the GPU chips used to power AI, the demand for which is itself accelerating. Yet should there be signs that the chip cycle is cooling and/or competition from rivals such as Intel or AMD is set to increase, the stock’s very demanding valuations could look vulnerable.