This has many investors debating whether to cut back exposure to growth stocks, which have outperformed for many years, in favor of value stocks, which have tended to do well in a new cycle.

As investors, we don’t look for traditional value or growth companies, but those with the potential to be “quality compounders” and “transition winners.” From that perspective, we see two potential problems with this debate: At the big-picture level, we question whether framing things in terms of traditional cycles makes sense at all anymore. More immediately, we think it is easy to mistake quality compounders for traditional growth stocks—and that abandoning them now would be a mistake.

Durable Competitive Advantages

We define “quality” as the ability to sustain a high return on investment, regardless of any cycle, due to durable competitive advantages in a value chain with high barriers to entry. This is often referred to as a “competitive moat.”

These companies are “compounders” because the steady free cash flow they generate can be used to finance future growth through innovation, new capital investment or acquisitions. They don’t need to borrow or raise equity, which means they can continue to invest during downturns when other companies are retrenching and paying down debts.

That makes them highly adaptable, which is a key strength in a time of value-chain disruptions and transitions such as the de-carbonization of energy, changing consumer priorities, broadening access to health care and financial services, and the digitalization of the economy. This is what we mean when we say they are potential “transition winners.”

These companies can look like traditional growth companies—after all, they do indeed grow their business and earnings faster than the market average. But not all growth companies are truly sustainable quality compounders. It is perfectly possible to grow earnings by diving into an exciting new market, taking on lots of debt, or ignoring environmental or social sustainability. But without a genuine “moat,” competitors could soon attack your share in that new market; debt tends to turn from a booster to a burden; and negative externalities are eventually internalized as a loss of customers, a reputational scandal or “stranded” assets. Quality compounders avoid all of these short-term growth traps.

Valuations

Are quality compounders expensive at the moment? Are they likely to lag behind value stocks over the coming months?

We find a lot of quality compounders in what we call the “Digital Enterprise,” “Access to Healthcare” and “Conscious Consumer” value chains, and they often become large companies, almost by definition. We would categorize the likes of Alphabet, Thermo Fisher and Amazon as quality compounders and the valuation multiples of businesses like these do appear high.

But there is much more to this category: We also find plenty of midsized, lesser-known companies across a variety of value chains that exhibit these characteristics.

We also think it’s important to remember that a reasonable or even cheap valuation of a decade of steadily compounding growth can look like an expensive valuation for the next two or three years of growth—precisely because it is steady growth, not supercharged. Many investors underestimate this cumulative effect of sustainable compounding.

When it comes to lagging value, we would argue that less sustainable traditional growth companies are more at risk than true quality compounders. These are like strong cyclists, with inner reserves to push through temporary headwinds. They may not be out in front for a while, but neither are they likely to be left far behind. Because they can continue to invest and adapt even through the worst of a downturn, they often use that opportunity to take market share and build on it during the recovery.

Transition and Disruption

If that makes you think of the companies, big and small, that have thrived through coronavirus and the resulting digitalization of our lives, that is no accident—and it brings us back to our point about the big picture. The whole growth-versus-value debate is predicated on the idea that there are economic cycles caused by industrial supply-and-demand mismatches. But we would argue that the application of technology, across all sectors, has all but smoothed out those cycles.

In our view, that means intangible capital, including research and development and human capital, but also brand reputation and good corporate citizenship, are now more important in value creation. It also means that we live in a world not of industrial cycles but of long-term transitions and periodic disruptions. Without the disruption of the coronavirus pandemic, which hugely accelerated the transition to a digitalized economy, who’s to say that the last decade of expansion wouldn’t have persisted for many more years?

As we have noted, it is the quality compounders, cash-generative, free of external financing risk and often rich in intangible capital, that are supremely adapted to thrive in a word of transition and disruption. And that is the real reason we believe it is problematic to think in terms of growth-versus-value—especially if it leads investors to ease out quality compounders along with traditional growth stocks.

Not only might we abandon companies that can keep up the pace when other growth stocks struggle; we might also lose our grip on the sustainable transition winners across a range of value chains—the businesses most likely to consolidate their positions through the disruptions ahead.