Growth stocks in an environment of rising interest rates

aroominyork

I’ve watched Pension Craft’s video on “What To Invest In As Interest Rates Rise” where the bottom line is his view that interest rates will rise and value stocks will perform well as a result. He says “Rising interest rates are toxic for (growth, momentum and small cap growth) funds… they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates... During a crisis period growth comes at a massive premium and if a company can generate growth through a crisis then you’ll be willing to pay a very large premium for that company’s stock.”

What I do not grasp is why future cash flows are discounted – considered less likely to materialise at the anticipated rate? – if interest rates rise. Can someone please explain?

MaxiRobriguez

Growth companies take on a lot of debt in order to grow.  If interest rates rise then that debt has to be serviced. Many of those companies will not be making any sort of profit which exacerbates the issue.

More mature companies should have stable-enough profits, their debt burden lower as a % of capitalisation and a smaller debt cost given record of payments.

aroominyork

So if you are investing in growth funds, you would focus on those with low debt and high returns on their capital (which sounds quite Fundsmith)?

MaxiRobriguez

aroominyork said:

So if you are investing in growth funds, you would focus on those with low debt and high returns on their capital (which sounds quite Fundsmith)?

If I was focusing on growth companies then it would be on those with the largest potential for growth...

Ultimately it's just another consideration for investors to think about. Same as value stocks, some will have apparently serviceable debts today but tomorrow may have lower revenues and margins which make it harder for them.

Prism

Growth companies will do just fine in a rising interest rate environment however their stock price will likely not keep up. It is the valuation of those growth stocks that will be the issue. The 1970s nifty fifty is a decent example of what happens when a growth company like McDonalds is priced for low interest rates but instead you get high ones. The company did amazingly and the stock price went nowhere.

maxsteam

aroominyork said:

 “Rising interest rates are toxic for (growth, momentum and small cap growth) funds… they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates... 

Someone is talking bs. It is not growth stocks that should be avoided if you anticipate rising interest rates. You should avoid companies with high debt ratios for what should be obvious reasons.

aroominyork

Thanks Maxi/Prism/Max. So should the (generally highly regarded) Pension Craft guy have said “Rising interest rates are toxic for (growth, momentum and small cap growth) funds whose growth is based on high levels of debt... they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates...”?

What would be a straightforward metric to assess how much debt a company is carrying relative to its size, perhaps using the financials on this page as an example?

coastline

We've already seen a switch between growth and value over recent months but obviously don't know where it goes from here ? 
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The market itself has already absorbed a rally in bond yields where it's now near pre crash 2020 levels.
 United States Government Bond 10Y | 1912-2021 Data | 2022-2023 Forecast | Quote (tradingeconomics.com)
Rates took years to rise and fall and all moves had a mini cycle. If you consider a move from say 10% to 11% year's ago that's probably not much different from a move from say 0.25% to 0.35% today. With all the government debt around the world will they be that bothered about lifting rates to kill off inflation ?. That link was broken in the GFC 2008 and never followed since.
Federal Funds Rate - 62 Year Historical Chart | MacroTrends

Apodemus

aroominyork said:

What would be a straightforward metric to assess how much debt a company is carrying relative to its size, perhaps using the financials on this page as an example?

Debt/Equity ratio.  In this case, about 12.

Apodemus

...or perhaps more significantly, the debt/equity ratio has grown from a fairly stable 3.6-4.2 over the first four years in your table to 12.3 in the most recent figures to April '20.  On it's own that doesn't tell you much, but it indicates a significant change in the business, which might be worthy of further investigation.

AlanP_2

maxsteam said:

aroominyork said:

 “Rising interest rates are toxic for (growth, momentum and small cap growth) funds… they have a lot of cash flows projecting into the future because those cash flows are growing very rapidly. If that’s the case then when interest rates rise the value of those future cash flows is discounted very heavily and that means growth stocks are particularly sensitive to rising interest rates... 

Someone is talking bs. It is not growth stocks that should be avoided if you anticipate rising interest rates. You should avoid companies with high debt ratios for what should be obvious reasons.

Not total bs and not just applicable to those companies with high debt levels.

Analysts use Discounted Cash Flows as one tool in their armoury. This is particularly relevant for the low / no profit companies like Tesla etc where today's price is based on future trading conditions and revenue / profit.

Microsoft / Netflix would be other examples, the "market" has a pretty good idea on what revenues and profits they will generate from subscriptions over the next x years.

Their market value is influenced by analysts and the advice they give their fund managers and traders for styles / sectors / companies relative to each other as the place to be in the next few weeks / months / years.

If you discount 20+ years of potential revenue at 5% instead of 2% you get a much lower "value" today hence rising interest rates do impact on the share price of growth companies.

This is driving the move from Growth to Value styles we are seeing at the moment.