Why interest rates matter to growth investors
What is the term structure of interest rates
The bond market allows investor and borrowers to come together over different time horizons and for borrowers of different risk. For a given level of risk, in this post we focus on treasury or sovereign meaning ‘risk-free’, the market consistently providing borrowing costs over different tenors. For example the cost to borrow will vary for 5 years and 10 years. Adding all those costs to borrow together results in a yield curve covering multiple borrowing periods, this is called the term structure.
The principles of valuation
The appropriate valuation of a financial asset is the present value of its cashflows. Unless a market is subject to a negative rates regime the time value of money means cash to be received in the future is worth less than cash today. I previously provided some basic metrics on time value of $100 in the December blog here by way of illustration of this very point:
What has changed since that December 2020 blog is US long tenor base rates have risen. On 9 March 2020 for example the 30-year US Treasury yield closed at 0.99%. In Christmas Eve 2020 the yield was 1.66%. By end January the yield had rocketed to 1.87% and at the time of writing on Friday 19 February 2021 the yield has risen further to 2.14%.
The pace of US Treasury issuance combined with improving outlook for economic recovery is driving long term interest rates higher.
The reality of high growth stocks
Everyone loves a growing company. Metrics on what is growth tends to vary – start ups tend to talk to revenue as they continue to incur losses as they grow while more mature businesses for example tend to talk in terms of earnings, cashflow or even return on capital metrics.
So what is a realistic growth rate to assume for a growth company? Lets use Google as our example given its unquestioned and sustained success. Because 2020 was such a bizarre year we will consider the recovery from GFC to 2019, a sustained bull market, to ensure we can capture the most positive picture possible.
The rewards for investing in high growth companies is clear and Google shares a good example of that. Throughout history owning good businesses has been key to wealth creation.
The impact of a bull steepening yield curve
High growth businesses which are delivering impressive growth in revenue, but still producing accounting losses and consuming cash, are attractive to investors because they can generate cash in the future.
Speculative excess aside, if a business was never expected to make a profit why would anyone wish to be a part owner of a business? It will inevitably exhaust its resources. Either the business raises additional equity capital, diluting the owners’ stake, or it ceases to exist.
So the market is absolutely assuming profits for (currently unprofitable) high growth businesses, just far out into the future. When interest rates are very low more of that future cash generation is able to be recognized today. If money has no time value then $100 today is the same is $100 in 5 years’ time. The sting in the tail is the inverse is also true. If money changes from being free to being expensive then cashflows many years into the future lose their value today.
Because many high growth businesses’ cashflow generation is expected many years into the future this means their valuations are more sensitive to increased long tenor bond yields. The further out their cashflows the higher the sensitivity.
Actions to take
A reasonable valuation model will allow some work to develop an understanding of interest rate sensitivity. Were an investor concerned about interest rates rising, and the impact of just interest rate changes on their investment portfolio, then interest rate futures could be used to hedge the calculated interest rate risk.
If the investor was purely worried about the share price of a particular share investment, which implies more than interest rate changes to valuation models, then in the near term put contracts can hedge exposure. There are challenges using options such as decay and timing will never be perfect as the market may not be fixated on interest rate risk for periods of time.
A good solution is to stress your valuations against a number of scenarios, including changed interest rates, and build a portfolio of good quality investments which will do well in good times but will also hold up well regardless of market conditions. This will likely steer investment selection towards the added certainty of near term earnings.
This article is based on publicly available information considered reliable however it is not a personal recommendation nor does it consider any particular investment objectives, financial situations or needs. To the extent this constitutes general advice, this advice is provided by Balmoral Asset Management as part of providing an information service. This information service is not for the purpose of providing financial product advice. Readers should consider their own circumstances and, if appropriate, seek professional advice, including tax advice, before acting.