VALUE AND GROWTH STOCKS:
- Value and growth stocks valuations will be impacted differently by a shift in the monetary policy outlook
- Value tends to outperform the growth factor when the Fed increases interest rates
- When interest rates fall in the economy, growth companies outperform their value counterparts
When the Federal Reserve adjusts its monetary policy stance by either raising or lowering borrowing costs, the investment landscape changes, becoming more friendly or more hostile to the equity market. In this article, we will discuss how valuations and performance of value and growth stocks tend to be affected by rising and falling interest rates, but before we get to that, some context and definitions need to be established.
Growth companies are often unprofitable and have speculative prospects, but investors are willing to pay a premium to own them because they have an innovative business/product that has the potential to deliver above-average returns over a long-term horizon, although there are no guarantees. They are riskier and therefore more volatile than the market in general, but their share prices usually rise faster than typical stocks because of their strong earnings growth outlook. Often, these high-flyers focus on increasing future revenue at the expense of delaying profitability, reinvesting their earnings into product research and expansion, so they do not frequently distribute capital to shareholders through dividends or buybacks.
Value stocks sit on the opposite spectrum. These are mature companies with a well-established business, solid balance sheets, proven history of financial performance and steadier but low growth over time. Despite their high quality and solid fundamentals, they have fallen out of favor and lost their “WOW” factor, so they trade a discount to the market and appeared undervalued based on various financial metrics such as price/earnings, price/book, cash flows, etc. Value companies typically pay dividends, offer lower volatility, and carry less risk than the market, but their share prices rarely experience explosive upward movements similar to those seen in the growth universe.
It is clear from the above introduction that different stocks have different characteristics; they are not created equal, so they will be affected by changes in monetary policy in dissimilar ways, but to try to gauge the possible impact, it is first necessary to understand a little about valuations. Very simplistically, the value of a company can be thought of as the present value of expected earnings.
By buying Apple’s shares, for example, a long-term investor has acquired an ownership claim in the company's profits over time. To assign an intrinsic value to the perpetual cash flows associated with the business’ operations, analysts first forecast earnings growth and then discount the sum of the projected income stream to today's dollars using a discount rate, usually a risk-free rate such as the 10-year U.S. Treasury yield. This is where interest rates play a huge role in equity investing.
Let’s now analyze two imaginary companies, with different earnings profile over the next decade to determine how their value are affected by a changing interest rate environment. To do so, we’ll rely on a basic discounted cash flow model, using the formula below:
The model is very basic and omits key variables for simplicity, but for our purposes is enough.
1. Value Company: Company XYZ is a well-established oil producer. XYZ is expected to generate $1,000,000 in cash flows next year, and grow them by 4% every year for the next 10 years. Let’s now value this company with the U.S. 10-year yield at 0.25% and then at 3%.
2. Growth company: Company ZZZ is a recently founded tech firm that launched an innovative cloud storage software. ZZZ is expected to generate $50,000 in cash flows next year, and grow them by 90% every year for the next 10 years. Let’s proceed to value this company with the U.S. 10-year yield at 0.25% and then at 3%.
The tables above show that higher discount rates produce lower equity values, but the effects vary across investment styles. In general, however, growth companies will be more sensitive to rising interest rates because of the nature and path of their cash flows: little in their early stages, large later in their life cycle.
Going back to the two hypothetical examples, growth company ZZZ lost 21.3% of its value when the discount rate used went from 0.25% to 3.0%. In real life, the less attractive valuation will likely coincide with a steep drop in the company’s stock price. Company XYZ was also affected by the change in the rate environment, but its present worth only fell by 14.3%, suggesting that companies with value characteristics may fare better when monetary policy becomes more restrictive.
Focusing on real life examples, the charts below are composed of two panels. The upper panel shows the ratio between IWD (iShares Russell 1000 Value) and IWF (iShares Russell 1000 Growth), and the lower panel displays the U.S. 10-year yield by itself.
Chart 1 is from January 2020 to May 2020. During this period, when the 10-year yield dropped from about 1.89% to 0.66%, the IWD/IWF ratio declined roughly 19%, pointing to strong growth outperformance.
CHART 1 - IWD/IWF RATIO VS US 10-YEAR YIELD (JANUARY 2020-MAY 2020)
Chart 2 is from January 2022 to May 2022. During this time span, the 10-year yield climbed from 1.50% to about 2.85%. Simultaneously, the IWD/IWF ratio advanced roughly 20%, indicating strong value factor outperformance in an interest rate environment.
CHART 2 - IWD/IWF RATIO VS US 10-YEAR YIELD (JANUARY 2022-MAY 2022)
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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
Diego Colman, Market Strategist for DailyFX
07 September 2022