A notable feature of the current stock market decline is how disproportionately growth stocks have been impacted:
The S&P 500 is down only about 12% year-to-date, while the technology-focused NASDAQ is down about 18%. Apart from Energy (+41%), the top performing sectors are low-growth, dividend-heavy Consumer Staples, and Utilities stocks. This result is not too surprising as high-growth stocks are more impacted by rising interest rates than low-growth stocks. Suppose there are two companies: both earn $1 million, but A Corp grows at 5% per year and B Corp grows at 3% per year. Assuming an 8% return for equities, A Corp should be worth $33.3 million and B Corp would be worth $20 million. Although both companies are going to make $1 million, A Corp intuitively is worth more than B Corp because it grows faster.
Now assume that interest rates went up and investors now require a 10% return for equities. Assuming no change in outlook for either company, A Corp’s share price should fall by 40%, while B Corp’s share price should fall by 29%.
Investors in both companies lost money, but investors in A Corp lost more than those in B Corp. The reason this happens is because A’s growth becomes less valuable when interest rates are higher. Why wait for the future when you can get more money today?
This is exactly what has happened with growth stocks over the last 5 months. where many leading companies including Amazon, PayPal, Shopify, and Nvidia have seen their share prices drop by 50% or more from highs. Stock price movements often drive the narrative, and investors are now questioning the competitive position of many of these firms, but the simple reality is that for high-multiple, high-growth stocks, a small change in interest rates can have a significant impact on the value of the stock price. Add to the fact that many of these firms are also seeing slowing growth due to COVID-reopening and supply chain issues, and the sharp drop in share prices are not surprising.
Of course, this works both ways : low growth “value” stocks materially underperformed in the decade-plus after the financial crisis as interest rates stayed far lower than what most people expected. This is why we at Baskin Wealth Management prefer to focus simply on owning high quality businesses rather than attempting to time interest-rate related swings, as business quality and earnings growth is ultimately what drives the stock price in the long-term.
Although we certainly have no idea when the stock market or sector performance will turn, there are encouraging signs. Shares of some former high-flyers rallied significantly after earnings despite weak financial results and a disappointing outlook, suggesting that sentiment is improving. Valuations for many growth stocks are now at all-time lows, and trading at lower multiples than low-growth consumer staples and utility stocks. Google, which is growing revenues at 15-20% per year, is trading at a lower P/E ratio than Colgate-Palmolive, which should grow sales at 2-3% at best.
Although the recent drawdown is painful, we do not want to compound the mistake by changing our investment strategy and selling our high quality companies when they are out of favor. Paying up for defensive stocks now by selling cheap growth companies would be akin to selling low and buying high: exactly the opposite behavior that an investor should have.
One of my favorite examples about the rewards of owning quality businesses through strong market fluctuations is TFI International (formerly known as TransForce). TFI International is a major trucking company that has done a terrific job of generating returns from acquisitions. We first invested in TFI’s shares in 2005 and TFI has delivered a 17% compounded annual return for us since, far outpacing the S&P/TSX Index. However, it was not a smooth ride. TFI’s stock has fallen by over 25% six times since we owned it including an 80% drop due to the financial crisis.
Through the severe volatility, we believed that TFI was a high-quality company with an intelligent management team that would continue to create value over time, and that is ultimately what ended up mattering. We expect a similar result to happen for most of the names we own today despite the market volatility.