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By Dries Dury,
Fund Manager DPAM
As we head into 2023, the stronger impact of higher interest rates on the valuation of resilient growth stocks could be offset by their faster earnings growth, thereby enabling them to stop underperforming the market. However, if interest rates peak and inflation slows down further, as market trends have begun to indicate, growth stocks should be in a strong position relative to the market. In this article, we will discuss the impact of rising interest rates on quality growth stocks, examine what drove stock market returns in 2022, and consider the potential effects of further interest rate increases.
THE IMPACT OF RISING INTEREST RATES ON GROWTH STOCKS
At the start of 2022, the MSCI All Country World Index was trading at a forward price-to-earnings ratio (PE) of 20, which is equivalent to an earnings yield (EP) of 5%. As interest rates rise, the earnings yield must also increase to maintain the attractiveness of stocks relative to bonds. Throughout 2022, interest rates rose in response to high inflation. The 10-year US government bond yield increased from 1.5% at the start of the year to 3.9% at the end of the year. As a result, the MSCI All Country World Index’s PE ratio dropped from 20 to 15, resulting in an earnings yield of almost 7%. This means the earnings yield of the index increased by 2 percentage points, which is roughly in line with the rise in interest rates. A decrease in the PE ratio from 20 to 15 implies a negative return of 25%. However, the market drop was not as severe because earnings growth offset the decrease in valuation.
The impact of rising interest rates on high-growth stocks was more significant. At the start of 2022, high-growth quality stocks had an earnings yield of close to 2.5%. An increase to 4.5%, assuming no earnings growth, implies a derating of 44% (i.e., the PE ratio would fall from 40x to 22x). Adobe, for example, which began the year with a PE ratio of 40x, ended the year at 22x.
If interest rates were to increase by another 2 percentage points, the earnings yield of the market would rise from almost 7% to 9%, resulting in a derating of 23% (i.e., the PE ratio would fall from 15x to 12x). For high-growth stocks, the earnings yield would increase from 4.5% to 6.5%, resulting in a decrease of 31% (i.e. the PE ratio would fall from 22x to 15x). In other words, in the event of a hypothetical further interest rate increase, the PE ratio of growth stocks would still be impacted more than that of the market, but relatively speaking, it would be much less than the first interest rate jump. The difference in derating, assuming stable earnings, was 16% for the first interest rate increase (a derating of 44% for high-growth stocks vs. 25% for the market), whereas for the second one, it is only 8% (a derating of 31% for high-growth stocks vs. 22% for the market). However, earnings do not remain constant, and resilient growth stocks can have earnings growth that is much stronger than that of the market in a downturn, especially if they have recurring revenues and little operating and financial leverage.
Stock market returns in the short-term are largely driven by changes in valuations, making it difficult to predict and adapt to these fluctuations. However, in the long-term, the return of a stock is primarily determined by earnings growth rather than valuation changes. An example of this is Mastercard, which in 2013 was trading at a similar multiple as it is now, but has returned 375% due to its earnings per share increasing fourfold. In 2016-2018, this dynamic was evident as the election of President Trump led to a growth sell-off due to a 100bps increase in interest rates. Despite another 50bps increase in interest rates, earnings growth became the dominant driver of returns, leading to quality growth stocks outperforming.
PERFORMANCES IN 2022
Last year, three factors drove relative market performance: valuation multiples, perceived defensiveness, and perceived pricing power. Marsh & McLennan, an insurance broker which earns a fee on written insurance policies, ranks well on all three factors, and strongly outperformed the market. Mastercard still did relatively well despite its growth stock status, because of its obvious pricing power (i.e. Mastercard takes a fee on nominal consumer spend) and relative defensive character.
As a result of the market’s focus on multiples and defensiveness, sectors like consumer staples and pharma did very well, but also reached relatively high valuations. For instance, at the end of 2022, PepsiCo was trading at a forward price-to-earnings ratio of 27, compared to Alphabet which was trading at 17x (despite the latter’s massive cash position, investments in currently loss-making ventures like self-driving cars and the cloud, and stronger mid-term growth outlook).
In 2022, almost all the underperformance of quality growth stocks relative to the market happened in the first three months of the year. Investors were primarily focused on the P of the PE ratio and not the E. Rapid valuation resets can make overreacting to market changes as risky as inaction.
After those first months of 2022, investors started focusing more on the E of the PE ratio. Execution of many quality growth companies remained strong, with low to mid-teens earnings growth in the third quarter of 2022, showing significant beats to consensus.
As we proceed through 2023, we are hopeful that their resilient nature will continue to shine through. Quality growth companies are exposed to structural growth trends, like digital transformation, biopharma, ageing, energy efficiency and the emerging consumer. They provide mission critical services or products, which helps in pricing inflation through. They have very profitable business models, with healthy balance sheets and visible, recurring revenue streams, which helps in cyclically challenging times.
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