Hello and welcome to the Unhedged newsletter. Today, we have some interesting topics to discuss. First, the National Bureau of Economic Research has made an interesting statement about US long-term interest rates. Although not entirely true, it definitely catches our attention. The 10-year Treasury yield has surpassed 4.6%, which is quite alarming. However, there is a silver lining – the yield curve is now less inverted. Feel free to reach out to us at [email protected] and [email protected].
Now let’s move on to our first topic: why small caps have not been successful. In July, we presented a compelling case for small caps based on valuations and growth potential. At that time, multiples seemed reasonable compared to the expensive S&P 500, and the Russell 2000’s price/book ratio was below the historical average. Additionally, there was a growing story around a soft landing. We believed that as recession fears diminished, the Russell would rally.
However, things didn’t quite pan out as expected. While the S&P has been falling since July, the Russell has experienced an even greater decline. The Russell’s valuations have shifted from cheap to ultra-cheap, with its price/book multiple now in the bottom quintile of its historical range.
So what went wrong for small caps? One factor is a downward revision of market growth expectations. As recession fears subsided, the market pricing of GDP growth dropped from around 3% to 2%. This is evident in the outperformance of defensive stocks compared to cyclicals.
Another challenge is the uncertainty surrounding the economic cycle. Small caps typically perform well in the early stages of a cycle, but with the current ambiguity, it’s unclear when an early-cycle rally will occur.
Lastly, higher interest rates are impacting small caps. S&P 600 interest expense per share has reached a record high. Small-cap indices consist of many companies with thin margins, including a significant number of unprofitable ones. This raises the probability of defaults.
One intriguing point to consider is the rise of private equity, which may have taken some vitality away from the small-cap universe. With capital flooding into PE funds, they may have already identified and acquired potential small-cap companies, leaving behind a weaker group. This is supported by the fact that one in three companies in the Russell are projected to be unprofitable.
However, it’s important to remember that any asset class can make sense at the right price. Small caps are historically very cheap, so there may still be a strong case to be made for buying in. If you have any insights on this matter, please share them with us.
Now let’s move on to our second topic: the relationship between interest rates and stocks. It’s a common belief that rising interest rates negatively impact growth stocks. However, as we’ve discussed before, this theory is an oversimplification. When interest rates and inflation expectations rise, not only does the discount rate on future profits change, but growth rates can also be affected.
Despite numerous attempts to dispel this misconception, analysts and pundits continue to propagate it. For example, Bloomberg recently stated that the tight policy threat is causing declines in high-flying tech stocks. They claim that higher discount rates diminish the appeal of growth companies with long-term prospects.
But here’s the twist: tech stocks actually performed well during a period of rising interest rates in the summer. So why the contradiction?
Let’s try a different approach, one that involves numbers. Below is a simple net present value analysis of two fictional companies – one focused on growth and the other on value. Both companies have the same profits in the first year, but the growth company is projected to grow at 5% for the next 10 years, while the value company grows at 2.5%.
To calculate the present value of each stock, we use the 30-year Treasury yield as the risk-free rate and the equity risk premium from December 2021. We also factor in a terminal growth rate by reducing both growth rates by 1%. The results show that the growth stock appears expensive, with a price-to-earnings ratio of 38, while the value stock is relatively cheaper at 20.
Now, let’s introduce a scenario where interest rates rise. We use the current 30-year Treasury rate and equity risk premium while keeping everything else the same. As expected, both stocks experience price declines due to the higher discount rate. However, the growth stock suffers a larger drop in value compared to the value stock.
Next, let’s assume that both companies have inflation-offsetting pricing power, but to different extents. The growth company has higher pricing power, allowing it to increase nominal prices and raise its profit growth rate to 7.5% per year. The value company can only achieve a growth rate of 4% per year. We also increase the terminal growth rates slightly. In this scenario, the value stock experiences a greater decline in value compared to the growth stock.
This analysis demonstrates that the “rates up growth underperforms” theory falls apart as soon as we introduce an additional variable – pricing power. The ability to increase prices gives growth companies a competitive advantage, allowing them to offset the impact of rising interest rates.
It’s worth noting that many growth stocks, particularly in the tech sector, possess high barriers to entry. Companies like Apple, Microsoft, and Amazon have significant pricing power, making them less susceptible to the negative effects of rising rates. In fact, we’ve previously argued that big tech companies may even prove defensive in a downturn.
To conclude, the inverse relationship between growth tech stocks and Treasury yields is not straightforward and requires a deeper understanding of behavioral finance rather than relying solely on macroeconomic variables.
Finally, I recommend reading an article in The New Yorker that has sparked a lot of debate on Twitter. People seem to have strong opinions about it.
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