2022 Lane Reports

Interest Rates, Inflation, and Growth Stocks?

Friday, April 1, 2022 10:00 am
by Kenneth N. Green

Interest Rates, Inflation, and Growth Stocks?

By Kenneth N. Green, CPA, MBA

As I write today, the yield on the benchmark 10-year Treasury note is at a twelve-month high of 2.49%, up from 1.72% on March 1st. To the surprise of nobody, the Fed raised interest rates by 0.25% last Wednesday, March 16 and the median projection now expects the fed funds rate to increase to 1.9% by the end of this year. And, the 2023 projection was also revised up from 1.6% to 2.8%. The rising borrowing costs have impacted growth stocks, particularly those that are not profitable and whose values are based on their future earnings potential. The data that has emerged in recent months indicates that GDP still is expanding although not consistently across all sectors of the economy. The February reading indicates expansion on the economy for the 21st consecutive month after a contraction in April 2020.

The rapid growth of the M2 monetary aggregates and supply chain disruptions have caused the rising inflation that has along with the Russian invasion of Ukraine, brought about the market correction this year. Inflation should trend lower over the balance of 2022 however, by how much and for how long is an open question. All the same, we believe that quality growth stocks offer better protection against inflation than bonds and cash.

Inflation acts as a silent tax on real returns across all asset classes. Bond principal and their interest payments lose value at the inflation rate. Gold offers inflation protection over very long timeframes, too long to be useful to individual investors. The record of inflation protection from commodities is uncertain and is accompanied by high volatility. Only equities offer growth in real terms. The historical evidence of staying invested in stocks through periods of inflation is incontrovertible. And within equities, good quality growth companies that trade at reasonable valuations vis-a vis their historical norms will provide the best protection against rising inflation. If those companies pay dividends, the payouts should rise at or above the inflation rate as well.

Stock valuations will likely suffer as interest rates rise in an inflationary environment. The higher discount rate on future earnings reduces the present value of the future cash flows. Technology start-ups whose growth prospects are years in the future will see commensurately greater share price reductions. Value stocks with shorter-duration cash flows will be less impacted by rising interest rates. We have seen this phenomenon occur since the beginning of the year. The strategy going forward is not to abandon growth companies, but to search for those whose valuations are more reasonable in light of their future earnings prospects.

Quality growth companies have pricing power, high gross margins, and low capital intensity. These characteristics will protect company earnings from inflation. Strong companies are able to increase their unit prices without losing customers. Those companies with high gross margins and high fixed costs relative to their variable costs, will have economies of scale. Their revenue growth, without the commensurate rise in costs, will translate into earnings growth. This is found commonly in technology and related technical services companies. As to capital intensity, companies that must invest heavily to maintain their earnings power will face greater challenges from inflation. Less capital-intensive companies generate most of their earnings in cash and thus the assets on their balance sheets are less impacted by inflation.

Which companies fit the profile of quality growth companies? Software companies in general and cloud software stocks in particular do. These stocks soared during the pandemic with most peaking this past November. Since then, these stocks have plummeted 37% vs. the Standard & Poor’s 500 Index which is down 7% as of this writing! Still the industry is relatively expensive and the stock prices may correct further. Why have they fallen so much, so quickly? First, their valuations have sky-rocketed these past several years to levels that are more than two standard deviations above their trend lines which is how we designate a danger zone. Second is due to the Federal Reserve indicating that interest rates will be rising throughout 2022 and into 2023. Such increases have a greater impact on fast growing businesses like cloud software as their expected future earnings become discounted at higher rates. Does this mean that their decade-long growth phase is nearing an end? We do not believe so. In fact, we believe there may be a long way to go still.

The software industry is unique in that it has maintained a very high growth rate for the past decade. Just how long such accelerated growth can be maintained is open to debate. And in the near term we do not foresee an end. Nonetheless, with their high growth rates, software stocks are prone to serious volatility. The industry has incurred declines of 20% to 35% about every eighteen months this past decade so patience and discipline are vital. So too is it necessary not to buy more of these than your risk tolerance will allow and to spread your risk by buying at least three such companies.

The legacy on-premise software license model is rapidly moving to the cloud-based Software-as-a-Service (SaaS) model. With this comes the growing need for improved cybersecurity as the cloud presents greater potential for security breaches. In the U.S. alone there has been a new threat every couple of months. Today, Okta, an identity and access management security company, is the latest victim.

As the cloud expands, so will the need for cybersecurity. The key for investors is to use the current industry correction to carefully build positions and be prepared to hold those positions for at least two and preferably four or more years.

Kenneth N. Green is the Senior Vice President and Director of Investments at Marc J. Lane & Company, the investment affiliate of The Law Offices of Marc J. Lane, P.C.

We would welcome the opportunity to help you evaluate your investment strategy in light of your objectives, risk tolerance and time horizon. Please feel free to reach out to Marc Lane, in confidence. His email address is MLane@MarcJLane.com

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