Such divergence is also seen across whole industries or subsectors. For instance, the price-to-sales ratio—a company’s market capitalization divided by its sales—has risen sharply for software companies as discount rates have fallen. By contrast, it hardly changed, or “rerated,” for the auto components sector (Display right). This shows the relative discount rate applied to software has fallen more than it has for auto components, but if rates rise, we believe that benefit will begin to reverse.
This especially applies to early-stage growth companies, where there is less (if any) free cash flow available to shareholders in the short to medium term. Such companies offer characteristics that are similar to bonds with longer durations (i.e., maturing in 10 years or more), as their weighted cash flows are received further out than companies that are more profitable today. These companies, and long-duration assets in general, have benefited from many years of falling rates compared to more mature companies. Importantly, the relative benefits have increased as rates have fallen. Mathematically, when rates drop from 5% to 4%, the benefits to long-duration assets are greater than those if rates fall from 10% to 9%.
Rates Set the Tone, But Quality Should Guide Selection
We live and invest in a seemingly more disruptive, competitive environment than ever, while inflation pressures are also accelerating. This can be seen very clearly in places like the US housing market and across durable goods. Combined with long-term risk-free interest rates that sit today near 1%, and tight risk spreads, it’s unlikely that discount rates will fall much further. For high-growth stocks with limited current profitability, the elimination of the rate-driven tailwind arguably looks like a relative headwind.
If rates increase just moderately, both high-quality and value stocks with less reliance on cash flow generated well in the future stand to benefit on a relative basis. Ironically, rising interest rates might have very little impact on a company that is already pricing in a finite lifespan, such as an upstream oil and gas producer.
Consistent Profitability Matters
Nobody knows where interest rates will head. But as economies further cycle from recovery to expansion, it’s especially important to lean in to consistent, highly profitable business models. There is evidence that highly profitable companies, as measured by return on assets (ROA), tend to stay that way for multiple years, while less-profitable ones are more likely to falter.
We believe that profitability-based metrics, such as ROA or return on invested capital, will be especially telling of quality business models if interest rates rise (thereby increasing the cost of capital and the discount rates used to value future cash flows).
As economies continue to improve and lift markets to higher valuations, investors will need to focus on companies with resilient business models that can deliver solid returns in the post-pandemic world. And when quality is at the heart of fundamental analysis, investors can create portfolios with the potential to deliver more consistent performance across changing economic cycles.