Why inflation (doesn't) matter to analysts

One of the purported reasons for our high growth stocks declining recently has been the specter of higher inflation. This didn’t make sense to some on this board, nor to me. I think I finally found why analysts believe this.

Here’s an interview of Gary Black by David Lee. I’ve set the link to start at the appropriate part:
https://youtu.be/NF8nkXLqeIE?t=1157

So when I look at companies like Google or Shopify I try to come up with a Fair Value. So, when I discount back, usually I like to use future earnings and future PE’s…I discount it back and - here’s back to your earlier question on inflation - if inflation keeps going higher, I have an 11.6% discount rate today, based on a risk-free rate of 2%. If the 2% goes to 3%, the value I’m coming up with goes down.

Which, in my view, is nonsense. If you’re coming up with “future earnings” and not using inflation on those, then why would you use inflation to discount them back to today? And if you are using inflation on the future earnings, then it should be close to a wash when you also use that same inflation rate to discount back to today.

I really believe these analysts get so wrapped up in their “models” and their “discount rates” and other math that they don’t even think about what’s really going on anymore. As Saul says, focus on how your companies are actually doing. If their business is growing rapidly then don’t let the noise bother you.

Inflation can hit some companies harder than other, but look at it from a fundamental business point of view. I can’t imagine that inflation affects a company’s need for internet security or database storage. I might say that higher inflation would mean less home refinancing and so Docusign might have less business, but that’s even a stretch to think that’s a major impact.

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Analysts need to remind people that they need help investing, and one way to do that is to throw a bunch of math and big words around.

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There’s the discount cash flow model, but there also the fact the Fed pumped a bunch of money into the economy of which much of it wound up in the stock market. If the fed now has to fight inflation it may put an end to the stimulus that has driven stocks higher.

Furthermore if bond yields go down they become more appealing as an investment vs. stocks.

I think anybody who puts out a DCF model on DocuSign is wasting their time because they’re just going to wind up with “precisely wrong” estimates but I can imagine investment houses having their analysts do just that because it’s how an “informed investor” approaches the market.

People don’t question why stocks go up 100% with interest rates dropping or even think about it, but get all up in arms when stocks fall because interest rates are rising.

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Which, in my view, is nonsense. If you’re coming up with “future earnings” and not using inflation on those, then why would you use inflation to discount them back to today? And if you are using inflation on the future earnings, then it should be close to a wash when you also use that same inflation rate to discount back to today.

My view, for what it’s worth, and at the risk of this whole thread being considered off-topic:

Not once have I seen backward-looking revenue growth rates for any high-growth companies discussed here adjusted for inflation. So those growth rates, along with the corresponding projections for future growth, implicitly include whatever (if any) impact inflation had.

The question to answer is whether high-growth stocks have pricing power to boost their subscription prices over time. I suspect many of them do, but that’s a company-by-company evaluation.

Inflation can hit some companies harder than other, but look at it from a fundamental business point of view. I can’t imagine that inflation affects a company’s need for internet security or database storage.

Inflation didn’t affect companies’ need for technology hardware either. But the pricing dynamics of hardware led to consistent deflation in hardware prices. That made what looked like high-growth hardware businesses in the 1980s and 1990s suffer in the 2000s – even though demand remained high.

I’m not saying subscription-based models are necessarily doomed to the same fate. But you have to be willing to ask the question.

In the end, no matter how good your product or service is, your customers have to be able to buy it. There’s a limit to how much a business can spend. If inflation hurts your customers, it hurts your own business. You’ve already seen how many of your high-growth companies deal with a crisis over the past year, but it’s been a long time since we’ve seen any company have to deal with a rising interest rate environment. After disproportionately large up-moves in stock prices, I’m not surprised to see what many here might consider a disproportionately large down-move as a kneejerk reaction.

good luck,
dan

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I think the inflation fear and the Fed rates panic is smoke, the talking heads need something to talk about, so they need to build a wall of worries. I believe the rotation is just normal motion of the ocean, markets rise and fall, mostly around alpha.

Look, our growth momentum stocks had a blistering 12 months, and a lot of that was elevated by the COVID story, WFH, and easy cash from the near-zero interest rates. But the market is looking forward several months ahead. Near the end of 2020 and into early 2021 it was clear vaccines were coming and COVID was about to be last year’s story. At the same time our stocks had rallied to extreme overbought levels, just look at any price chart.

Let’s look back a year; COVID arrived; investors panicked and bailed like the sky was falling, they sold out of everything. Then investors went looking for alpha, triggering the rotation at that time, selling out of entertainment, travel, hospitality, energy (remember the oil crash?!?!), banks and several other sectors, and buying up tech, especially SaaS and WFH tech. That’s why several of our momentum stocks were up 100+% in mere months. That is normal, folks. That’s what investors do. That was the COVID rotation.

Now the vaccine story has come out, and there is a new sheriff in the white house. Investors are now unwinding the COVID rotation, taking profit (you don’t go broke taking profit), and looking for alpha as always. That is normal. We are in the recovery rotation now. So where do you find alpha these days? Well with the economy roaring back and social distancing restrictions being lifted, the stocks left for dead at the side of the road a year ago are the ones likely to bounce back, so money has shifted into energy, airlines, financials, and into many of the COVID rotation victims.

Inflation and interest rates have a part in the story, but mostly for bond investors who are making a lot of noise because interest rates have bottomed and are not going any lower. Falling interest rates make bond prices rise. Rising interest rates make bond prices fall. So, with the economy coming back, the Fed will eventually stop buying bonds (taper tantrum redux), and then eventually will raise interest rates.

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