Why are Growth Stocks Impacted by Rising Interest Rates?
Only learned traders can win (a healthy dose of experience won’t hurt, either). Some of the things you need to master are:
- The principles of order flow mechanics and analysis
- Risk management (such as the 2% rule), and
- An understanding of the impact of liquidity on asset prices
The first and last points may seem very similar, but the point of this article being about interest rates, it is important to understand the effects fundamentals can sometimes have on the bigger picture aspect of liquidity (such as Quantitative Easing).
For this reason, we have decided to share with you the reasons why growth stocks are impacted by rising interest rates.
What are Growth Stocks?
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Growth stocks are companies that tend to increase in capital value rather than yield income. Their value is usually based on the expectation that they can grow faster than the rest of the market, with most of the earnings reinvested into the company, as opposed to paid out in dividends.
Often, these growth companies focus on enhancing their revenues and bear consistent losses in a bid to do so, relying heavily on debt financing. However, since these companies often have competitive advantages such as superior network effects and scale advantages, they eventually shift their focus toward dominating the market and becoming profitable.
What Are the Various Features of Growth Stocks?
Different investors can view growth stocks differently due to their market perceptions and interpretations. However, below are a few characteristics that are common and apply to all of them:
1. Higher Price-To-Earnings Ratios
Almost all the growth stocks exhibit a high price-to-earnings ratio. The primary reason for this is that the investors of these stocks expect their prices to grow shortly.
This creates a positive sentiment and favorable trading ground for growth stocks leading to robust demand and buying interest, causing them to trade at about 25 times, 50 times, or even 100 times (approximate) higher than their earnings.
2. Absence Of Dividends
As mentioned earlier, growth companies are usually start-ups, and they initially focus on generating revenue by delaying profits. Thus, they re-invest whatever they earn in the initial stages, thereby creating little to no scope for distributing dividends to its shareholders.
Further, it must be noted that the investors of the growth stocks intend to earn through capital appreciation rather than getting rewarded in the form of dividends.
3. Most Famous Growth Stocks
Every established business organization was once a growth company that aimed at profitability after focusing on revenue development.
For example, Amazon Inc. has always been considered a growth stock due to its immense future capability and growth potential. In the period between June 2020 and September 2021, the company’s price-to-earnings ratio hovered in the range of 58 to 106.
Similarly, Boston Properties Inc., Upstart properties Inc., Liberty Broadband Corporation, EQT Corporation, etc., are some of the present-day growth companies reflecting a high P/E ratio and revenue growth.
Why do Interest Rates Increase with Inflation?
As per a rule of thumb, interest rates and inflation levels maintain an inverse relationship with each other. This implies that with an increase in the level of inflation, the interest rates also increase and vice versa.
This primarily happens due to two primary reasons, which are:
1. Decreasing Purchasing Power
Inflation negatively impacts lenders/ savers by decreasing their purchasing power. This forces the countries’ central banks to push the interest rates north to compensate the lenders for the rise in prices.
2. Lenders’ Demands
Inflation arguably favors the borrowers as it allows them to give returns to the comparatively fewer lenders given the present market circumstances. The lenders, in this case, suffer from actual negative returns.
Why Are Growth Stocks Falling?
In testing times, where inflation levels and, consequently, the interest rates are on the rise, the growth stocks suffer gravely. This happens due to the following reasons:
1. Increased Interest Cost
Debt has always been a prominent item on the balance sheet of the growth companies. This primarily happens because most growth companies prefer to leverage and enhance their revenue using debt capital.
Since the lenders demand a higher interest rate during inflation, this increases the interest expense of the growth companies causing them to pay comparatively high interest.
This lets the investors doubt the otherwise rosy future of a growth company and causes them to become bearish.
2. Higher Commodity Prices
Inflation or the rising interest rates cause everything to increase in price. The various factors of production, such as labor, raw material, land, etc., tend to enhance in value, further laying stress on the profitability of the growth companies.
3. Struggling Consumers
It is a fact that if the cost of doing businesses increase, then the value of the final product also increases. This represents the negative effect of inflation upon the consumers causing them to buy products and services at a higher price.
This leads to a fall in demand for goods and services, forcing growth companies to revise their revenue targets.
If a typical stock market is divided into two categories based on the nature of stocks, then value and growth stocks are considered the two most famous varieties.
While the former represents the under-priced companies, the latter represents the promising stocks currently available at a high price-to-earnings ratio.
The rising interest rates usually have a more significant negative impact on the growth companies than the value stocks due to their inadequate cash flows and little to non-existent profits.
An increased interest cost combined with an increase in the factors of production makes the final products expensive, causing the consumers to struggle. This leads to a fall in demand, and ultimately the growth companies get impacted.
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