Here’s something that may be of no real value to anyone.
I made this tool to play with stock valuations as they relate to changes in earnings growth rates, discount rates, and time horizon. After all, we’re in a period where all of these rate assumptions are in flux. Discount rates, driven mostly by the Federal Reserve’s anti-inflation policy, have risen dramatically this year. Expected growth rates have come down too, particularly among the “winners of the pandemic.”
An important assumption when applying this analysis is that all securities are priced fairly for their assumptions, prior to adjustments in earnings growth rate (hereafter just “growth rate”), discount rates, and time horizon. This may or may not be fair.
For instance, I think may be some discount for growth stocks, because the timeframe where those really turn out to be winners on the basis of dividends and cash flows are very long. Much longer than most mutual fund holding periods (indeed, longer than the average lifecycle of most active mutual funds).
Likewise, any comparison between stocks implies a fairly uniform shift in discount rates across asset classes, which may or may not be realistic. Bubbles, for instance, are an example of assets receiving very low discount rates, and high growth expectations relative to what is later justifiable. Eventually, the growth falters, and/or investors adjust their discount rates to get a greater margin of safety. This brings the valuations crashing down.
For instance, if a stock with a 30% growth rate suddenly slows to a 10% growth rate, its expected valuation drops 89% (assuming a 6% discount rate and a 20 year time horizon over which those earnings are discounted).
What’s also interesting about this example is that it doesn’t make a big difference whether the starting discount rate is 6% or 10% doesn’t offer much refuge. At a 10% discount rate, the valuation falls 86% (rather than 89%).
Worse yet, if discount rates (not just the growth rates) also rise from 6% to 10%, then the stock is suddenly worth just 7.1% of its original value. Astonishing! That’s not just “oh the bubble popped but if we hold on the panic selling will end and we’ll get it back.” Oh no. That’s the justifiable valuation. If indeed panic selling drives it below fair value, you could lose even more and hope for a sentiment shift to get you back to 7.1% of your original purchase price.
Of course, rising interest rates hurt the value of everything. For a stock priced for 20% growth, with no changes to that growth assumption, an increase in discount rate from 6% to 10% causes that investment to lose 45% of its value.
A stock with 10% growth (again, no changes except the discount rate), loses 38% of its value.
A stock priced for zero growth (which should trade at a PE between 8 and 11 by the way), thereafter is worth 29% less than it was before the change in interest rates.
Indeed, that has been the story of the last year. No asset classes have been “good” to own. Everything is down. But value stocks are down less than growth stocks (and we value-oriented-investors will take our wins where we can get them).
This has been a reversal from the prior trend of accelerating growth (among the Pandemic Winners) and lower rates that took place starting in April 2020. A company which went from 10% growth to 30% growth, amidst discount rates that dropped from 10% to 6% would theoretically be worth 13x as much after making these adjustments. Of course, some of these stocks were already priced so richly that they gained merely 2-4x in the marketplace.
Interestingly, it seems like all these variables move together. Morgan Housel has pointed out that time horizons are longest at market tops and shortest at market bottoms. In other words, when things are going well, people blithely expect that they’ll hold these great-performing stocks forever, through thick and thin. Then, during hard times, each day seems to last forever and the thought of another bad year is simply too much to bear.
Likewise, discount rates reflect the degree of risk built into a valuation. High discount rates assume trouble lies ahead, whether we know what form it will take or not. We expect to be handsomely compensated for the risk. And finally, growth rates expand when the economy is going well and business conditions are good, and contract when the going gets tough. It isn’t uncommon for earnings to decline, or even go completely negative in a recession. This, of course, is temporary, but it does bring a dose of reality to those companies expecting to grow 30% a year, forever. Going forward, they might expect significantly slower growth.
There’s another interesting way to make money, besides growth stocks, Value Investing! The main way to make money in value stocks is to buy companies with depressed valuations, and hold them through to a change in fortunes. Often these are low-growth, no growth, or negative growth companies. Many are actually losing money when they are at their most ripe for investment. But, often, these struggling companies get their act together. At least, on a statistical basis. OSAM and Research Affiliates have described this phenomenon in more detail, but check out this math below.
When I modeled a company going from -10% growth to 0% growth (ie, shrinking company stops the bleeding), it gains 69% in value. Even if rates rose form 6% to 10%, it would still gain 34%.
Better yet, when a company accelerates from 0% to 10% growth, it gains 107% in value. Even if rates rose from 6% to 10%, it would still gain 47%.
And best of all, when a company goes from -10% to +10%, it gains 346% in value. Even if rates rose form 6% to 10%, it would still gain 178% in value.
This makes “value” as a factor worth considering for your portfolio. While you won’t own anything particularly sexy, you can still make decent money.
Additionally, these returns are somewhat more consistent across time. Whereas “growth” stocks (and the market in general) often have 10 or more years of boom-times, followed by 10+ years of poor returns (the cycle repeats itself), “value” is steady-eddy. It won’t shoot the lights out, but it is a lot less likely to have a losing decade.
The worst thing about value, is that it suffers in relative terms, sometimes for several years in a row. Even if a value strategy is posting 7-10% returns over a decade, growth stocks might be doing 10-20%. That is a long time to underperform.
Finally, a dose of humility is never a bad thing when it comes to markets and investing. It is important to remember that growth stocks provide much of the growth in our economy. Moreover, many growth stocks continue to dominate for decades, and it is these stocks (not value stocks) that drive much of the index-level gains over long periods of time. Look at the top members of today’s S&P500: Apple, Microsoft, Google, Tesla… these are, or were recently, high growth companies. They all have delivered something new and valuable to the world, and used those profits to make even newer and more valuable products and services. They are important, not only as investments, but as companies that expand access to knowledge and technology, providing better technology and living standards with fewer resources. They are worth owning too. Just don’t get too excited, nor too despondent as the market cycle rolls along.