Growth Investing Ain’t About the Rates

Executive Summary

Rising rates hurt investors; claims on profits in the future are simply worth less if you discount them at a higher rate. As growth stocks deliver their cash flows deeper in the future, their worth is hit harder than the average stock. In this note, though, we conclude that this effect is much less strong than one might think, as the growth rates of even the growthiest of growth stocks tend to decelerate over time. As a result, this year has presented an opportunity for value investors to take a fresh look at growth companies, especially Quality growth companies.

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
-- attributed to Mark Twain

Jeremy Grantham likes to cite the aphorism above for good reason, and it applies particularly well to stock market investing. Everyone knows that rising rates are bad for asset prices and stock markets tend to react to changes in the discount rate – indeed, aggregate stock market movement arguably is the change in the discount rate for equity investors. However, the impact of a changing discount rate on growth stocks seems to us to be almost universally overstated. This is especially true in our area of focus, growing Quality companies, which have an extra layer of protection in rising rate environments because they are less reliant on capital markets. Speculative growth companies, on the other hand, tend not to be cash generative and must rely on external funding; therefore, their cost of capital is much more sensitive to rising rates.

Of course cash flows in the distant future are worth a lot less if you discount them at a higher rate. $100 in 30 years is worth $30.83 discounted at 4% and $5.73 discounted at 10%, a full 80% less at the higher rate. But there is no company we know for which we would project growth rates 30 years in the future with a straight face. We are skeptical that anyone owns a crystal ball that clear; assumptions of perpetual growth rates are doomed to disappoint.