Setting the context
To say that 2020 has been a volatile year for a vast majority of the population, both personally as well as professionally, would be an understatement. And so it has been with markets which tested the depths of despondency back in March but have recovered with a vengeance since.
Many traditional “value investors” have been lamenting the underperformance of “value investing” during the last decade. This aspect has been exacerbated by the crisis with the chasm between “growth” and “value stocks” starker than it has ever been. Those that have missed out on the rally of the last 6 months have argued that the market is out of sync with fundamentals. However, I am not particularly convinced by this line of reasoning. While there may be pockets and individual stocks which may be overvalued (as is the case at any point in time), I do feel there is a method to the market’s madness (in fact I am consistently surprised how often markets turn out to be right in the aggregate). At the risk of being presumptuous, In this post I aim to explore that the market may be onto something giving higher values to high growth companies as opposed to “value stocks”, even though there may be pockets where it may have under or overshot.
Low rates = higher values/ multiples
“I would say that’s (what interest rates will do) the most important question in the world… and I don’t know the answer” – Warren Buffett
With interest rates where they are, it is important, at least in my view, to assess the impact that they have on value. With a simple DCF set-up (check the appendix for details on assumptions), I have plotted the value of a company at varying levels of interest rates (10%, 5% and 1%) and growth rates.
It is not a surprise that lower interest rates result in higher values, all else being equal. Thus, a company growing at 10% deserves a higher multiple in a 1% interest rate environment than in a 10% interest rate environment.
What is more interesting, however, is that while value increases for all companies at lower interest rates, these low rates magnify the difference between low growth and high growth companies with value increasing at an increasing rate for high growth companies. In other words, growth becomes more and more valuable as interest rates fall, all else being equal. In the example above, the difference in value between a company that is not growing vs. a company that is growing at 30% is 8x in a 1% interest rate environment vs. only 4x in a 10% interest rate environment.
Not only does this concept have a theoretical underpinning, it also flows from logic – as interest rates become lower, there are relatively less number of companies that can grow at high rates. As an example, nominal GDP growth during the decade ended 1985 in the US was about 9.5% when the average 10-year T-Bond rate was 10.4% over the same decade. By contrast, nominal GDP growth during the last decade (2010-20) was less than 4% and the average 10-year T-bond rate was 2.4% during this period. Thus, you are more likely to find companies growing at 20% in a 10% interest rate environment than you are to find them in a 1% interest rate environment. With the same pool of capital fighting for limited opportunities, the prices are bound to rise at increasing rates.
If there is one takeaway from the above, it would be this – the lower the interest rates go, the more important they become in determining the value of a company. No wonder then that even Warren Buffett considers the question of what interest rates will do to be the most important question in investing currently!
But is growth panacea to all problems?
So, does this mean that the differential between low growth and high growth companies should be much higher relative to history across the board? In other words, is growth the only or the most important determinant of value? Not really and this is where a word of caution is in order on two counts. First, the above simple set-up assumes that as interest rates change, other things remain constant, i.e. companies continue to earn the same return on capital, there is no impact equity risk premiums, etc. And secondly, the above proposition holds true only if we assume that growth is value creating and all companies earn the same return on capital irrespective of their growth rates.
To be specific, one major assumption underlying the above analysis is that the incremental return on capital during the high growth period will be 30%, irrespective of whether interest rates are 10% or 1% (beyond the high growth period, I have restricted the incremental return on capital to the cost of capital of the company).
And this is where I think the debate should be – not whether high growth companies deserve higher differential multiples vs. low growth companies but which companies have sustainable competitive advantages which will allow them to earn high returns on capital along with maintaining their high growth. Unless a company can earn a return that is higher than its cost of capital, it hardly matters whether it is growing at 1% or 30% (in fact in some situation, it may be value destructive to grow faster!). Only companies that earn a high return on incremental capital accompanied by high growth deserve much higher premiums in the current interest rate environment relative to history. And figuring out which companies can pull this twin act off is the hard part in investing.
Appendix: DCF Assumptions
| Assumptions | High growth | Terminal |
| Sales (at t = 0) | 1,000 | |
| Margin | 10% | 10% |
| Rf | 1% | 1% |
| Beta | 1.00 | 1.00 |
| ERP | 5% | 5% |
| Cost of capital | 6% | 6% |
| Growth | 40% | 1% |
| ROC | 30% | 6% |
| Reinvestment rate | 133% | 17% |