How Interest Rates Affect Growth vs. Value Stocks

Considering that arithmetic again, think about the market we have been in. It has been dominated by growth stocks. These are stocks that trade at premium valuations. Some are fast-growing businesses that are expected to produce more and more income. Some have cool concepts with no income at all (see our Greg Oden post). Either way, the market Is valuing future cash flows for these names at historically low rates, which has translated to high valuations.

Now, think about value stocks in the market of the past few years. They have been demolished by growth stocks, and the valuation differences are notable. 

We believe rising rates may continue to affect growth more negatively than value. We are seeing that play out as large Nasdaq names have lagged the S&P in recent months. In addition, we’ve seen a few more “growthy” names with seemingly great earnings reports have not been treated favorably by the market.

At current valuations, market participants expect growth stocks to maintain extremely high growth to support these valuations, especially given the mathematical impact of discounting future cash flows at a higher rate. We think that’s a pretty high hurdle to mount. Value stocks just have to be less bad than they are expected to be — the discount rate of their future cash flows affects them to a lesser degree. 

To illustrate this point at the stock level, look at the chart below on the largest stock in the S&P 500. Pulled from Bloomberg’s EQRV function, it shows the blended forward P/E multiple of Apple. This multiple is a common way to illustrate or gauge one measure of valuation.

A few things jump out.

• First, look at what 2020 did to Apple’s valuation. It went nearly vertical. 
• Next, despite the reduction of valuation to start 2021, this measure of valuation is still over a standard deviation higher than the average over the last five years.
• Finally, hindsight is 20/20, but Apple sure looked cheap back in 2016!

We are using this chart to drive home our main point; We think rising rates should affect growth stocks more negatively than value stocks. In our view, valuations are sky-high and the future cash flows of these businesses are priced for near perfection. 

Valuations do not increase simply because they have in the past. While many may think that to be the case, there is no way of getting around what a stock is — a claim on future cash flows. A value today is derived with simple math, with the discount rate a key input. Increase the discount rate while holding growth expectations constant, and valuations must come down. 

The good news is that prices don’t have to drop for growth stock valuations to come down. They can simply stall out while the fundamentals catch up. Either way, we do believe it makes sense to have value exposure for the remainder of 2021.

JD Gardner, CFA, CMT, is founder and managing member of Aptus Capital Advisors.