February 2022 – Valuing Securities – Part II
In the three months since our last Market Observer, the overall U.S. stock market is down over 6%, with global stocks down 4%. U.S. large cap growth stocks are in correction territory, off over 11%, and small cap growth down almost 20%. Value stocks, on the other hand, are holding up relatively better, with large cap value up almost 2% since early November. In this edition of the Market Observer, we will examine the influence of rising interest rates on stock valuations.
In our last Market Observer we looked at the important concept of discounted cash flow analysis (DCF) in valuing financial assets. You will recall that we used it to value bonds. We showed what happens to bond prices when the discount rate (a.k.a. the Yield-to-Maturity) changes and when the bond maturity date changes. We saw that bond prices fall (or rise) when the YTM rises (or falls). We also saw that the longer the maturity of the bond, the more sensitive it is to a given change in the YTM.
Now we come to the second part of our M.O. topic you have been waiting for, valuing stocks (thank you for your patience). Unlike bonds, valuing stocks using a DCF model is, unfortunately, not as straightforward. That’s because the cash flows are much more uncertain and harder to estimate with stocks than with bonds. Because of this, many professional equity analysts prefer to use other valuation methods. But this doesn’t detract from the importance of DCF as the linchpin of finance theory as applied to valuation of financial instruments. In theory, any stock can be valued by discounting future cash flows accruing to owners, in the form of dividends, stock buybacks, or some future estimated sales price.
DCF analysis can help us to understand what happens to stock prices as interest rates rise, especially growth stocks versus value stocks. Growth stocks, by their nature, have more of their cash flows further out into the future than value stocks. The reason for this is that growth companies are assumed to have much higher rates of growth in revenues and profits, which makes their stocks very popular with investors. Value companies, by contrast, are often thought to have their high growth years behind them, being further along the corporate life cycle. They also may have other operating or financial issues which make them unpopular with investors.
Knowing that cash flows far into the future are more sensitive to changes in interest rates, we can conclude that a rise in the discount rate caused by a general rise in interest rates should impact the prices of growth stocks more severely than value stocks, which have relatively less of their cash flows as far into the future. This chart illustrates the inverse relationship between interest rates and growth stock valuations, showing the Russell 3000 Growth Index (purple line) plotted against the yield on the 10-Year maturity U.S. Treasury Note (gold line) for the past twelve months:
The next chart shows the relative performance of growth stocks versus value stocks over the past year, with two additional lines representing the price of short-term and long-term bond funds. This chart is formatted to show the growth in a $10,000 initial investment in each over the past one year:
There are several things to notice here:
- Looking at the top two lines, we see that value outperformed growth until early August, then traded even with it until the end of the year, with the value index finally ending the period worth $11,540 versus the growth index value of $10,660.
- The bond funds (bottom two lines) clearly show their relative sensitivity to changing interest rates, with long-term bonds exhibiting much greater volatility compared to short-term bonds.
- Notice how all the lines (except short-term treasuries) drop off at the end of the period, corresponding to the rise in interest rates (from 1.5% to over 1.8% on the 10-year U.S. Treasury Note).
- Notice also how the value stocks declined significantly less than growth stocks with the rise in the 10-year treasury yield.
It is far too simplistic, however, to suggest that the only thing differentiating growth from value over the past several years are changes in interest rates. The critical consideration now is the relative valuation of the two groups. On a recent webinar with one of our value managers, the portfolio manager showed us a study they did of the U.S. stock market from 1999 to the present. They sorted the market into quintiles by the valuation measure of price per share divided by sales per share (the P/S ratio).
In 1999, around the peak of the Dot Com Bubble, the highest 20% of U.S. stocks by P/S ratio were priced at 9.3 times their sales per share. Today, the top quintile is priced at 15 times sales. This suggests that the high-flying technology growth stocks might well be ripe for a further drop.
Is this an inflection point for value investors after such a long period of relative underperformance? Time will tell, but it is hard not to describe those popular tech stocks as “frothy” (if not “bubbly”), at the very least. Remember that after the Dot Com Bubble burst, we had seven consecutive years where value outperformed growth.
In any case, it is still good to keep the concepts of the time-value-of-money and discounted cash flows in mind. After all, the idea has been around for an awfully long time. But then, don’t take that from me. Take it from Warren Buffett, the CEO of Berkshire Hathaway:
“…the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free rate (which we can consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”
Personally, I like birds. But birding is one of my hobbies, after all.
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 Clifford Capital Partners, Quarterly Webinar, 02/08/22
 Everything Is a DCF Model, Morgan Stanley Investment Management, by Michael J. Mauboussin and Dan Callahan, CFA, August 3, 2021