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Key Points
- Investors are grappling with the potential impact of a higher-for-longer interest rate regime on equity markets and our approach to investing.
- We account for the influence of higher rates on valuations by assuming multiples will contract somewhat over our five-year horizon. The dramatic increase in rates over the past two years has led to a level of multiple contraction that we typically see over a five-year period, resulting in attractive valuations for many of our businesses.
- A period of easy money following the Global Financial Crisis lowered barriers to entry across many industries and heightened competition. Now, higher rates are sparking a process of rationalization across several industries and many businesses with the scale and financial strength we target in our investment process are extending their competitive advantages, relative to weaker competitors.
Background
Long-duration assets, including growth equities, have been under pressure since late July amid the sharp rise in U.S. interest rates (nominal as well as inflation-adjusted, or “real” rates). Stronger-than-expected economic data, federal deficit concerns, and hawkish Fedspeak have resulted in the highest 10-year Treasury yields since 2007. Now, real rates sit at their highest level since the early 2000s. By itself, the sharp rise has fueled concerns about its potential impact on consumers, businesses, and the economy at large. However, it has coincided with violence in the Middle East and concerns about energy prices and a broader global conflict, leading many investors to question the value of equities, relative to cash and fixed-income alternatives.
With growing expectations that the federal funds rate and Treasury yields will remain higher for longer, many investors are questioning the potential impact on equities and how we’re responding in our portfolios. In short, we evaluate the higher rate environment through the lens of our six criteria. More specifically, we distinguish between the impact of higher rates on valuations (our sixth criterion) and a business’ ability to maintain above average earnings growth, financial strength, and its competitive position (criteria 1 to 5).
The Impact on Valuations
An upward move in rates reduces the present value of a business’ potential earnings and cash flows. As a result, the impact of rate fluctuations is typically most pronounced for high-growth businesses that derive a significant portion of their valuation from expectations for future earnings. This was illustrated in late 2021 through mid-2022, when the Federal Reserve embarked on one of the most aggressive rate hiking cycles in history at a time when valuations for growth equities were near all-time highs. This rate-hiking cycle resulted in a historically pronounced contraction in valuation multiples for high-growth equities. More recently, speculation that rates will remain at current levels for longer than previously expected has weighed on equities.
An upward move in rates reduces the present value of a business’ potential earnings and cash flows. As a result, the impact of rate fluctuations is typically most pronounced for high-growth businesses that derive a significant portion of their valuation from expectations for future earnings. This was illustrated in late 2021 through mid-2022, when the Federal Reserve embarked on one of the most aggressive rate hiking cycles in history at a time when valuations for growth equities were near all-time highs. This rate-hiking cycle resulted in a historically pronounced contraction in valuation multiples for high-growth equities. More recently, speculation that rates will remain at current levels for longer than previously expected has weighed on equities.
Our investment cases assume that earnings growth is our businesses’ primary value driver, and they typically model multiple contraction over our five-year investment horizon. This approach generally reflects the evolving growth stages of a business, the math of growing into a valuation as earnings expand faster than a stock’s share price, and a degree of overall conservatism. Implicit in this compression assumption is an expectation for some valuation disruption—such as a change in the interest rate regime—during our ownership.
In 2021 and 2022, we saw considerable multiple compression over a relatively short period, which explained much of the decline seen in the stocks of our portfolio businesses. Now, after earnings growth has accounted for all of Select Growth’s year-to-date return through September 30th, we’re encouraged that the portfolio sits at an attractive discount to the index on a growth-adjusted basis.
Looking forward, we believe the potential for another bout of significant multiple contraction for high growth equities induced by higher rates is reduced by two factors. First, the relative valuations of growth equities are now at more normal levels relative to the broad market and their history, especially when adjusted for growth. Additionally, the federal funds rate now sits near its expected terminal level, indicating that a significant further tightening of monetary policy is unlikely.
At the same time, inflationary pressures are easing, the lagged impacts of tighter monetary policy may slow economic activity, and consumer excess savings and credit availability are dwindling—all conditions that suggest lower rates.
Finally, some investors are concerned that we’re entering a period of structurally higher rates, rendering stocks less attractive. They might be right, given that rates were held artificially low over the past decade, a phenomenon unlikely to be seen again. However, history provides some comfort. Bank of America notes that higher rates have historically meant better growth and productivity, and that we’re seeing “seeds sown today for a productivity cycle similar to that of the mid-80’s to mid-00’s. Our analysis shows that from 1985 to 2005 real yields averaged 3.3 percent—higher than today—but over that time the Russell 1000 Growth Index still delivered 12 percent annualized total returns.1
The Fundamental Impact
The impact of higher rates on business fundamentals is nuanced and, in many cases, a positive for our investment approach.
Action taken during the period following the Global Financial Crisis through the years following the start of the COVID-19 pandemic created an environment of excess capital, reducing the barriers to entry across many industries and thus heightened levels of competition. A backdrop of low inflation and moderate growth allowed the Federal Reserve to artificially suppress rates. This period of “easy money” incentivized businesses to defer profitability to invest heavily to grab market share and retain talent.
Now, competitive dynamics are shifting in response to higher rates. Across industries such as streaming video, food delivery, and ecommerce, we’ve seen many market-leading businesses improve their competitive position as businesses with lesser financial strength or scale have been forced to pullback on spending. Meanwhile, the competitive environment in industries such as ecommerce and food delivery has rationalized as businesses without financial strength or attractive unit economics have become insolvent. In short, we believe the stringent application of our investment criteria positions our businesses well to improve its competitive position in this environment. Financial strength—often viewed as a risk-reducing or defensive characteristic—is now enabling select businesses to go on the offensive.
Meanwhile, the market is increasingly distinguishing between those businesses that can take the appropriate steps to prove their underlying profitability and those without a clear path to profitability. With this as a backdrop, we’re encouraged by the progress that many of our businesses have made in prioritizing profitable growth over growth at all costs. Across areas such as ecommerce, software, streaming video, and mobility we’ve seen many of our businesses rationalize spending yet maintain healthy levels of growth, resulting in profitability that exceeds market expectations.
Conclusion
Looking forward, we’re encouraged by the conditions created by higher rates. In our view, the end of easy money has made investors more discerning. We expect this will benefit the stringent application of our approach focused on market leadership, financial strength, and businesses we believe will sustain above-average earnings growth. With the competitive landscape rationalizing, we believe the progress our businesses demonstrate towards seeking to achieve our expectations will, in many cases, only be accelerated. We believe these dynamics, combined with the tailwind of reasonable valuations, position our portfolios well to deliver attractive returns over our time horizon.
1 Bank of America, “US Rate Shock FAQ,” October 11, 2023
Disclosures:
The views expressed are the opinion of Sands Capital and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. This material may contain forward-looking statements, which are subject to uncertainty and contingencies outside of Sands Capital’s control. All investments are subject to market risk, including the possible loss of principal. Readers should not place undue reliance upon these forward-looking statements. There is no guarantee that Sands Capital will meet its stated goals. Past performance is not indicative of future results. GIPS Reports found here.