Why Growth Stocks Hate Higher Interest Rates

The universal law of finance is this: The current value of any asset is the present value of all future cash flows.

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The reaction to Covid-19 has been a case study in economic theory. Direct cash payments from the government to individuals and corporations were made for the first time in 2020. This experiment in fiscal and monetary policy will be studied by economists for decades. There are many areas of exploration, but I am going to limit this discussion to growth stocks.

Before we identify the difference between a growth stock and a value stock, we need to review what a share of stock represents. A share of stock is simply a very small piece of ownership in a company. As an owner, you are entitled to your share of the company's future profits for as long as you own the stock.

This right to future profits is what gives the stock its value, which can be calculated with relative precision. The challenge in investing is not the precision of the calculation, but rather the ambiguity of the inputs into the calculation. Allow me to explain.

The universal law of finance is this: The current value of any asset is the present value of all future cash flows. Finance books are full of asset valuation formulas, but most boil down to optimizing a present value calculation.This applies to stocks, bonds and even rental properties. Unfortunately, the future is uncertain, making the "all future cashflows" component of the law uncertain. And what does "present value" mean?

Present value underlies the understanding that cash today is better than a promise of payment in the future. Present value explains why the lottery lump sum payment is so much less than the 20-year annuity total. What is not well understood is the impact that interest rates play on determining the present value. Let's use a simple example to explain.

Assume I win the lottery with a $300,000 payout over three years. Let's assume I don't want to wait three years to get my money. I could create my own immediate payout by taking out a loan and paying it back with the annual lottery payments. I would have to pay interest on the loan, so I could not borrow the full amount. Assume I can borrow at 10%. My loan would look like the following:

  • Borrow $90,909 + 1 year of 10% interest = pay off loan with $100,000 in one year.
  • Borrow $82,644 + 2 years of 10% interest = pay off loan with $100,000 in two years.
  • Borrow $75,131 + 3 years of 10% interest = pay off loan with $100,000 in three years.

Therefore $300,000 paid out over three years is worth $248,684 ($90,909 + $82,644 + $75,131) when interest rates are 10%. But what happens when interest rates increase to 20%?

At 20% interest, the present value of three $100,000 payments is $210,647 ($83,333 + $69,444 + $57,870). As you can see, the higher the interest rate, and the further into the future, the less valuable that future payment is today.

But what happens to the calculations if the future payments grow each year (this is what we would expect from a growing company)? Let's see what happens when future payments grow at 20% in a 10% interest rate environment.

  • Payment 1 year from now: $100,000/(1.10)1 (1 year of 10% interest) = $90,909.
  • Payment 2 years from now: $120,000/(1.10)2 (2 years of 10% interest) = $99,174.
  • Payment 3 years from now: $144,000/(1.10)3 (3 years of 10% interest) = $108,189.

At 10% interest, the present value of the three $100,000 payments growing at 20% is $298,272 ($90,909 + $99,174 + $108,189). Notice when cash flows grow at a rate higher than the interest rate, they get more valuable over time. This is why growth stocks can have a positive value even with negative current earnings. It is also why their price can fall dramatically if they miss their earnings forecast.

There are two takeaways from all this math.

• A growing future cash flow is worth more than a stable one, and the faster it grows the more valuable it becomes.

• Higher interest rates make all cashflows less valuable.

Armed with these two concepts, we can finally address why growth stocks hate higher interest rates.

The first reason is obvious: Higher interest rates make future cash flows less valuable. Therefore—all else being equal—when interest rates rise, future earnings become less valuable today because they must be discounted at a higher rate.

Higher interest rates also make the growth of earnings more difficult. For a company to grow, it must have access to capital to build factories, hire staff and expand operations. Higher interest rates make that capital more expensive. This inevitably slows growth, sending the two factors that drive a growth company's value in the wrong direction when interest rates rise. Investors can capitalize on the impact interest rates have on growth by shifting investments from growth stocks to value stocks during periods of rising rates and returning to growth when the Fed lowers rates.

It is no coincidence that the growth-heavy QQQ (Nasdaq 100 ETF) advanced at nearly double the rate of the DIA (Dow ETF) between April 1, 2020, and November 30, 2021, (QQQ + 116%; DIA + 64.7%)* when interest rates dropped to nearly zeroand Paycheck Protection Program loans were flowing into the economy. It is not a coincidence that the Nasdaq sold off much more than the Dow in the first quarter of 2022 as the Fed has announced they will be raising rates to fight inflation. The tech wreck in 2000 and the housing crisis of 2008 were both preceded by increases in interest rates.

The stock market has many mysteries, but behind some of them is fundamental mathematical logic.

* Return numbers based upon market closing prices on days listed.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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