Interest Rates and Growth Stocks

Earlier this month, Cliff Asness at AQR wrote a really interesting piece about interest rates and how they may not be as related to the valuation or performance of growth or value stocks as we all think.

This piece followed a paper from his colleagues at AQR (Thom Maloney and Toby Moskowitz) in which they suggested that it is possible, if not likely, that falling interest rates have very little to do with rallies in growth stocks over the long term, or with the underperformance of value-oriented strategies.

The paper basically suggested that, despite what we all want to see or believe, that the underperformance of value stocks is not motivated by a drop in interest rates.

This one is very hard to believe in practice, especially given how salient and fresh this most recent experience has been for all of us. In their abstract, they address this point:

‍“Despite eye-catching returns during a few episodes in recent years…the economic significance of any relationship (to bond yields or the slope of the yield curve) is small and not robust in other samples.”

After all, we had 6% interest rates in the tech bubble, right?

So Cliff, Toby, and Thom are suggesting that perhaps it is the case that interest rates falling as value was punished was more about short-term correlation than anything long-term, let alone causation. In other words, the “interest rates went to zero and drove long-duration growth stocks to the moon from 2017-2020” might possibly be a nonsense, post-hoc diagnosis.

Then there is the meta-slash-behavioral analysis where falling or low interest rates didn’t directly affect valuation from 2017-2020 as much as we perceived, but our beliefs in their relevance were complicit with a perfect storm of other influences in forming the false narrative that led to the wild overpricing of growth vs. value.

Apologies for the psycho-babble I wrote above. I definitely needed a little help writing that more clearly. What I was trying to communicate was that we might be giving interest rates too much credit. And thus, anything that subsequently punctures that false-narrative lets the air out of the hype-balloon; not because it should directly, but because people believe it helped to blow up the balloon in the first place.

Thom and Toby seemed open to the potential that this was possible:

‍“It is also possible that investor belief in such a relationship over this period strengthened it during recent episodes as a self-fulfilling prophecy.”

However, they still concluded that this was unlikely, and more likely that random variation was likely the main source of the strengthening. In Cliff’s follow-up piece, he doubled down on the notions proposed by his colleagues, and stated that value investing was “not even close” to being “just an interest rate bet.”

I don’t know Thom, but I do know Cliff and Toby; at least enough to know that – when playing with them – I am the sucker at the financial theory poker table. Indeed I agree with Cliff about most things related to financial theory, and quite a lot not related to financial theory too. But I wanted to test things myself, with a simple analysis from a practitioner’s perspective.

Apologies for keeping this extremely simple, but let’s imagine four different companies, each with a different level of growth. Let’s assume that – whatever this growth is today – it will converge upon the rate of inflation by year 11, and that this inflation will be 3%. Let’s also assume – very simplistically, but it shouldn’t matter for this exercise – that net income equals free cash flows.

Plotting these four securities against each other reveals something perhaps a little bit interesting. If we build a DCF here and convert that fair valuation into a current P/E ratio, we can see that there definitely is a difference between what you would mathematically pay for a slow-grower and a higher-grower at all times (aka in all interest rate regimes). That much should make sense to all of us. More importantly, we can see that this difference gets smaller when interest rates are higher, and larger when discount rates are lower.

As you can eyeball here, when risk-free rates are 10%, you would pay a smaller multiple premium (of 5.5x) for the faster-growing growth stock over the slower-growing value stock; but when risk-free rates are 1%, you would pay a much larger multiple premium (of ~38x) for the growth stock. At first blush, this appears to support a theory that interest rates matter for value.

But that doesn’t prove anything yet. What matters is the percentage premium (for growth over value) that you would pay in the different scenarios. Using the example above, in a 10% rate environment, you’d pay a 56% premium for growth, while in the 1% interest rate regime, you’d pay a 70% premium.

In other words, when interest rates drop, you mathematically would pay at least a little bit more for growth stocks than for value stocks. I’m using an extreme example here (risk-free rates falling from 10% to 1%) and even with this magnitude of a move in rates, we’d only bid up the growth stocks by about 14% (70% - 56%) over value stocks. And given the enormous degree of the actual growth stock outperformance we saw from 2017 through 2020, 14% is small potatoes in comparison.*

‍So, I am landing in the camp now where the move in growth stocks from 2017 through 2020 probably wasn’t caused or justified by a move in interest rates, but that people believed, and acted like, it was.** And given the actual move we did see in interest rates, the boys at AQR are probably right. The growth bubble that we experienced (and arguably are still experiencing) was not truly “driven” by interest rates falling. They mattered a little bit, mathematically, but Mr. Market’s belief in the false-narrative that they were the only thing that mattered perhaps was a main and important driver of growth’s outperformance, and value’s underperformance.