The Interest Rate vs. Growth Stock Fallacy (OT)

[cfee2000]

I recently posted a link to Jamin Ball’s substack in this OT post - https://discussion.fool.com/jamin-ball-quotcloudquoted-judgement….

Relevant there is his posts on SaaS valuations from 2016-2022 from a Price (he uses “EV”) to “Next Twelve Months” (ie. NTM) Revenue.

Some readers noticed that I said “The talking heads on TV will keep telling you that there’s a strong correlation between interest rates and growth stocks, and that with rising interest rates growth stocks will continue to get killed, but I’ve spent time modeling this data all the way back to 2004 with companies like Salesforce and I think most of these people have no idea what they are talking about“

I was asked off board to share the data/insights that led me to make such a claim, and thought it would be worthwhile to share with the board rather than do one-off replies.

Backing up for a moment, it’s worth mentioning that most of the “talking heads” chatter I’m referring to is coming from channels like CNBC where 90%+ of analysts are telling you to GET OUT OF YOUR GROWTH STOCKS and move into some garbage cyclical value stocks. And what is their reasoning for this? It’s almost always because “high interest rates are bad for growth stocks…blah blah blah” Seriously, just watch some clips from analysts on YouTube and you are going to hear this line over and over again.

I heard this so many times it’s almost like these analysts have secretly banded together behind closed doors to create a self-fulfilling prophecy that drives the market towards value stocks, and they keep beating the drum on this talking point regardless of how much growth stocks have already sold off!

However, that said, I still wanted to do my due diligence on interest rates vs. growth stocks to stay as objective as possible, so i decided to build on what Jamin did, utilizing a similar set of indices dating back several years, to judge for myself whether the data proves their point or vindicates my suspicion that they are full of BS.

To that end, I’m sharing the research that I’ve done so that you can judge (and manipulate via copy of you so choose) the data for yourselves.

Here’s a few links to Google Sheets that provide Growth Stock Index P/S Ratios and 10 Year Treasury rates dating back to 2010. I’ve shared 3 different versions of datasets that include a range of indices of our favorite growth stocks.

https://docs.google.com/spreadsheets/d/13oVutw1nRFIigmJ0iQCb…

https://docs.google.com/spreadsheets/d/1n6EDBBVABLlf9Uc5k-oK…

https://docs.google.com/spreadsheets/d/1Ml7H3pp4oZde2j4CaW0G…

Give it a minute to load and render the Charts on top of the data…

The data is transparent. You can see each stock I included in the index for each spreadsheet, so if you think I’m suffering from any sort of Confirmation Bias, I’m happy to poke holes in this and try to find anything that would prove contradictory.

That said, I’ve also looked for a correlation between P/S Ratios and other Yields (eg. 2 year, 10-2’s, etc) and I didn’t see any compelling correlations that would be more useful or insightful than what I’m sharing here.

Ok, so from my perspective, where do I see that these 90%+ analysts have a point? Well, if you are only looking at the RATE OF CHANGE for interest rates, and are only hyper-focused on what’s happened the last 6-12 months only, then the data can certainly back you up on rising rates (inverted) as a strong correlation to growth stock P/S ratios.

However, any analysis that goes back beyond 12 months really breaks down in terms of finding a tight inverse correlation between interest rates and growth stocks. In fact, in many cases, growth stocks actually rise as interest rates rise and fall as interest rates fall. You can see this in the trend data for instance providing a better DIRECT correlation between the years of 2013-2019 in terms of growth stock PS Ratios and interest rates moving in the same direction.

I would typically never go this far into OT territory to prove a point, but I’m so sick of the interest rate talking point echo chamber that I felt compelled to bring to light some raw data that cuts through that narrative.

Like Saul or anyone else on this board, I cannot predict the future and do not claim to be some kind of market timing expert, but what I can tell you is that COVID was not a “pull forward” for our favorite companies, it was a state change that made them even more valuable going forward, and at this very point in time, they are ~15-20% cheaper on average than they were before the pandemic even started!!

In summary, I could care less if interest rates in the short term go to 2% or even 2.5% this year given the historical data above. Right now, more than ever, I look at this as one of those rare opportunities to take advantage of an overly-hyped negative narrative against our companies and do as much buying over the next few weeks/months as possible while the getting is good.

Lastly, I want to at least acknowledge that there is some truth to multiples getting over-extended due to the rise in liquidity and low interest rates, but I contend that the narrative there is extremely overdone, and the markets have over-indexed to the downside, creating opportunities for longer term investors that can see the forest from the trees.

Hope you found this an insightful/interesting read.

-Chris

[ronjonb]

Nice work Chris!

This summary of yours resonated with that I had posted yesterday!

“…Right now, more than ever, I look at this as one of those rare opportunities to take advantage of an overly-hyped negative narrative against our companies and do as much buying over the next few weeks/months as possible while the getting is good…”

I wrote yesterday…

“…Sometimes…times like these are the best to get invested :)…”

Cheers!

ronjonb

[MFChips]

at this very point in time, they are ~15-20% cheaper on average than they were before the pandemic even started!!

Jamin’s data doesn’t really support your claim above, so interested how you arrive there.

From his Friday report (most recent):
“High growth software multiples are still elevated. Looking at high growth software median only - we are still 27% above pre-covid highs”

He defines high growth a little different than we do, but it’s his highest growth cohort.

[cfee2000]

Jamin’s data doesn’t really support your claim above, so interested how you arrive there.

Hey MFChips,

He does, just a little earlier in the paragraph that you pulled: “The overall median multiple is 15% below pre-covid highs”

Here’s the link for anyone interested in checking this - https://cloudedjudgement.substack.com/p/clouded-judgement-21…. He had also tweeted about the ~15% number about a week prior, and with the recent selling I’m sure it’s slightly lower (hence why I said ~15-20%).

A fair point you are making, though, as it relates to which quote is more relevant to this board’s favorite stocks, and the one you pulled in fairness is probably closer to (though I for instance only hold 4 of the top 10 stocks he has in that bucket).

The main point and the spirit of the post was more about interest rates vs. valuations of our growth stocks, though, and I think that data (which I published out in the clear) is a compelling counterargument to the echo chamber of voices giving blanket statements about high interest rates being bad for growth stocks without using data to back that up.

-Chris

[PuddinHead42]

Sorry, I can’t really agree with you. All value is relative and money is going to go where it is best treated. For a while, high-growth treated your money well. Interest rates were de minimis thanks to the Fed and they also were throwing money out of the helicopter. That put us in a “risk on” environment.

Many investors use discounted cash flow models and those absolutely use interest rates as the primary variable for calculating net present value. You may not believe this has an impact, but I do. When quant funds and hedge funds and other experienced investors make investments based on models like this, they move the markets.

When the Fed intimated they would raise rates near the end of 2018, the market tanked and I recall the Naz hit a 19-20% sell-off low. Our high-growth stock were hit harder. This was solely on the threat of higher rates.

This fall, Cramer, who is probably one of your least favorite talking heads, warned us early - high-growth stock will be severely hurt by rising rate. He was was write, like it or not.

The first chart you link to seems to show a complete inverse correlation between rates and PS/TTM - that seems do disprove your theory. Also note that for the last 20 years, rates have been mostly going slowly lower and lower - they even turned negative in some parts of the world. Which is to say, I don’t think your longer term graphs are meaningful because it is different now.

And yes, I do believe we pulled forward a lot of growth and value during 2020-COVID. That can and does happen. These SaaS stocks were changing the world and their growth was inevitable, but if you think Zoom did not reflect the unimagined growth it achieved, then you should think again. And we have all agreed here on this board that Zoom is a fine company and will be around and grow, but it is not high-growth or hyper-growth because everyone has Zoom already. That was a pull-forward.

I think a lot of people have confirmation bias. We are truly very smart on this board, but we have also seen ourselves be too smart. There are plenty of stocks (e.g. Upstart) that had brilliant research posted and we gobbled it up and it turned out to be wrong. So were we any smarter in the end than the ARK fund, or Wallstreet Bets, or the twitter flock? If we are, did it matter? We don’t drive the price of these stock up or down, so maybe it is “dumb” people, talking heads or “broken” models. Either way, our stocks are feeling massive pain and while they may continue to have strong subscription rates, and NDBRR, etc., the multiples (PS or PE) may well contract for years. We can’t know, but we will see.

Pete

*I am not an outsider coming to bash, I have been on this board many years but have not posted much in the last few. I think Saul converted me when he used to go bash the Westport message board ;-)I did used to contribute frequently and brought such stocks as LGIH and Dycom to this board (2015?) back before we were hyper-growth only. I have a large (and painful) holding of high growth stocks that I have not sold off in this market drop.

[cfee2000]

The first chart you link to seems to show a complete inverse correlation between rates and PS/TTM - that seems do disprove your theory.

PuddinHead42,

Speaking of your points on Confirmation Bias, the reason why I included that first chart was so you can see different vantage points, that one in particular being from 2018-2022, but please don’t cherry pick like that and ignore the other 2 charts which have a much wider band of history and correlation. While the correlation is strong for the first, it’s not for the other 2 which have much greater historical perspective, and with the first it’s very clear that the rate of change in that span of time is much more significant.

I am very aware of Confirmation Bias. This is why I, for instance, have taken the opposing view from the board on topics like valuation, revenue growth acceleration vs. companies generating FCF and operating leverage, etc, but you would only know this if you’ve read some of the things I’ve posted on this board.

If I wanted to hide data from the first chart to push a narrative, I could have, but the idea with 3 charts is to give you a balanced viewpoint that shows that recent history does show a strong correlation. The thesis I’m presenting is that growth stock to interest rate correlation has more to do with the rate of change than the absolute value of rates themselves, and if you take history as a guide, the data bears this out to be true.

That said, if you have a stronger case to make with data that there is in fact a correlation historically that I’m not seeing, then please do the work and show that and I will be open minded about your conclusions. Obviously the Index has to be created from something, and I did my best to cast a wide net of SaaS companies going back to 2010, but I’m also not going to sit here an claim there isn’t a possibility that there’s data out there that could make a strong case against it. However until I see a case made the contradicts my thesis with compelling data, then I will stand by the research I’ve done here.

-Chris

[CMFSoloFool]

Many investors use discounted cash flow models and those absolutely use interest rates as the primary variable for calculating net present value. You may not believe this has an impact, but I do. When quant funds and hedge funds and other experienced investors make investments based on models like this, they move the markets.

Pete hit the nail on the head.

Discounted cash flow calculations are designed to estimate future value, and interest rates are directly used to determine the discount rate. That is why institutions de-risk when rates go up. This fallout also happened to come at the peak of a period of hyperbolic price action driven by enormous stimulus related to the pandemic, so a lot of SaaS growth stocks had climbed well into nosebleed territory.

These institutions are not investing on emotion. The thesis for them is based on a formula that estimates future value, and when that value drops because the discount rate gets elevated, then they do move on. It’s nothing new. And it won’t last forever.