Interest rate affect on growth stocks

I understand the fear when stocks crash 30% or more in a short span of time. We always find negative reasons to justify the huge crash and fear about those reasons. In the worst case, we sell out all growth stocks and go to cash.

I had the experience in early 2021. In that crash, I thought in 2020, all SaaS companies got a COVID boost and they will slow down dramatically in 2021. it turned out not all SaaS companies slowed down. Most SaaS continued their growth trajectory. Some did slow down: e.g. PTON, ZM, DOCU, CRWD etc…

I think the anticipation of the negative effect of rising interest rate on growth stocks is more a self fulfilling prophecy than actual effect. It’s similar to anticipation of lockup expiration.

Rising interest rate causes short term sector rotations not permanent exit from growth stocks. How many people are using formula and interest rate to do discounted cashflow calculation(DCF) to obtain stock valuations? (Not that many people are good at math!) Chances are growth stocks are always expensive according to the DCF analysis and those DCF believers will wait a long time or never have a chance to buy the best growth stocks. It’s the reason value investors normally don’t own growth stocks, especially hyper growth stocks. They look at stocks like: Cloudflare, snowflake, Monday.com and proclaim in disbelief how they can have such high P/S . Simple: high quality fast growing companies are expensive. There’s no fixed fair valuation to assign to all companies because due to different market perceptions, each company has its own fair valuation. If the market likes a company more, it’ll get a higher valuation than a similar company. Valuation is just a guess.

Let’s use a couple winning growth stocks and see how they performed during the interest rate increase since last year.

Start date: 1/4/2021
End date: 1/3/2022
10 year yield: Increased from 1.10% to 1.66%


**Stock	    Start price	    End price	    Gain**
DDOG	         $91.23 	$163.83 	79.58% 
NET	         $74.59 	$126.16 	69.14% 
ZS	        $196.09 	$301.83 	53.92% 
	

Average gain: 67%

So how did a 1.10% to 1.66% increase in interest rate derail those growth stocks? If you do the DCF calculatoin with two different interest rate, the results will be very different and the stocks are not possible to have 67% gain in a year.

Good read:
http://www.blackrock.com/sg/en/insights/why-rising-rates-won…

P.S. My view on 6% is that it’s temporary. It’s due to pent up demand (demand of product is more than supply. ) and supply chain issue. Both will be solved over time. Note we don’t have a baby boom like 1980s so we won’t have prolong hyper inflation. Actually, sad thing to say many people died and there are few people than without COVID.

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Chances are growth stocks are always expensive according to the DCF analysis and those DCF believers will wait a long time or never have a chance to buy the best growth stocks. It’s the reason value investors normally don’t own growth stocks, especially hyper growth stocks. They look at stocks like: Cloudflare, snowflake, Monday.com and proclaim in disbelief how they can have such high P/S . Simple: high quality fast growing companies are expensive. There’s no fixed fair valuation to assign to all companies because due to different market perceptions, each company has its own fair valuation. If the market likes a company more, it’ll get a higher valuation than a similar company. Valuation is just a guess.

Sorry CloudL but I have to take issue with this statement. I’m a DCF believer; in fact I value all of my stocks using DCF (see here: https://discussion.fool.com/the-valuation-of-my-portfolio-350066…) as do many others on this board, and many respected growth investors (including Bert). Using DCF to value a company is a technique, not a religion.

In addition, there are a couple of very credible sources that assert that DCF is the only correct way to value anything, including a growth stock. In fact, here is a good article on exactly that, from McKinsey:

https://www.mckinsey.com/business-functions/strategy-and-cor…

Valuation matters a lot to any investor because you are making a bet that something will be worth more in future than it is now (if you are going long). In fact, valuation is the only thing that matters if you look at it like this. There is a difference between value investing of the quantitative kind and valuation. Valuation matters to all investors and DCF is one way of assessing that.

Interest rates are an input into the discount rate that is used in DCF valuations, so yes, if this goes up, the discounted value of future cash flows goes down. But there is nuance here: you have to take a view for every year in the forecast, and the 10-yr yield is already 10 years out and very low! Also, and more importantly, given the extremely high rates of growth of our companies, a 1% increase in the real interest rate for a year or so (this part is important - our companies have pricing power too, so can offset inflationary pressures) does not need to be material. That is why interest rate changes do not have a material impact in my DCF valuations.

I assert something different to dismissing DCF. I believe it is extremely hard to do a good DCF valuation for our companies because of their explosive growth, therefore it is at best another data point for consideration, and at worst a distraction. And I believe that our companies are relatively undervalued, regardless of the technique you use to value them including if you were using DCF (others on the board agree: https://discussion.fool.com/static-multiples-for-a-company-only-…)

My DCF valuations that I do in addition to, and informed by, the analysis of the individual companies gives me additional confidence and staying power in times like these.

Valuation techniques are not the subject of this board, which is why I won’t go on any further and I believe we should not get into a long debate on the matter, however I felt I had to set the record straight on this one.

-WSM

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hi WSM,

You are right that if real rates only go up for a while or so and start falling back again, then it won’t make much of a difference to your DCF.

However we are at negative real rates now (-1%) which is exceedingly rare in modern times and really exists for a prolonged period during the Covid era (prior to that, it was negative only briefly and mostly during recessions).

As we look past the pandemic and as QE wraps up, I believe it quite probable that real rates will re-rate permanently back to where it was before the pandemic - unless you believe that we are in a perpetual state of QE (not possible since that’s wrapping up) and recession-like conditions.

If real rates mean reverts, I believe we are nowhere near to a bottom even after this carnage.

However hypergrowth over time (this is important) should overcome that given its high growth; but we are getting hit now because there isn’t enough time for forward estimates to grow (the numerator in a DCF valuation) to overcome a rapid rise in rates (the denominator). I mean how much can forward estimates change in 60 days since real rates start ramping up in Oct/Nov?

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i see this like wsm.

Of course, there are some arguments that Saas/Software/Cloud stocks justify a higher valuation.
But unfortunately it is difficult to determine by how much it can be higher?!

I prefer to invest in companies that regularly generate high (and annually higher) free cash flows.
every year. With such companies, as wsm said, i can use discounted cash flow (DCF) analysis to determine at least approximate the intrinsic value of the share. And that is the most important thing in my eyes. Because you have realistic expectations through DCF. These may be a bit inaccurate, lets say ±30% are surely possible but for me it is enough to hold the share in the long term and not to panic to sell even in times like now.

In any case, I do not rely on novel valuation methods such as the so-called “Rule of 40” …

During the dot-com boom (year 2000), many believed in new valuation methods to make the high valuations look good.

Buffett (I know he is totally out of place here) is only so successful because he has stuck to proven valuation methods for 70 years! And historical data is especially important in this regard

So if this is offtopic.

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This 4 post thread has already illustrated how difficult (read: impossible) it is to measure valuation – no magic method is ever absolutely correct, and many unknowns factor in heavily.

This is why this is off topic. LET’S END IT HERE. I echo what Jon said in another thread: Let’s focus on what we can control.

Bear
Assistant Board Manager

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