Last week’s Consumer Price Index (CPI) report showed inflation reaching a 40-year high with prices up 7.5% in the last year. Even after excluding the more volatile food and energy inputs, inflation still remains shockingly high at 6.0% and is creating angst among investors, particularly those who have relied on the stimulative effects of declining interest rates and lower credit spreads from the Federal Reserve’s Quantitative Easing (QE) program. QE, combined with pandemic-related shifts in consumer and business behavior, contributed to a bubble in growth equities. With interest rates rising alongside the higher inflation numbers and QE starting its multi-year wind-down next month, we believe the deflation of this bubble has just begun. Similar to the unwinding of the dotcom bubble in technology names in 2000, it should lead to a de-rating in the most speculative and expensive of the growth equities.
While there has been significant pain already among the most speculative growth stocks, it seems too early to call for a rebound; significant headwinds, like rising rates and the potential for rising credit spreads will create headwinds to the lofty growth rates assumed in stock valuations. Growth stocks often carry a valuation premium to value stocks; the dispersion between these two groups of stocks is at a level not seen since early 2000. Below is a chart of the blended forward price/earnings (P/E) ratios of the Russell 1000 GI(RLG) compared to that of The Russell 1000 Value Index (RLV). Despite the large recent price declines, growth stocks continue to trade at a hefty premium to value (27x forward earnings, compared to 16x for value stocks).
Higher yields, including the prospect of a higher Federal Funds rate, should continue to narrow the valuation spread between growth and value stocks and similar to the post-bubble period of 2000 to 2002, it may take two to three years to fully unwind. In such an environment of rising rates, we expect that the market will continue its current path and shun:
- Equities of high-risk companies with unproven business models
- Tech stocks whose valuations suggest growth rates that are not sustainable
- Highly leveraged companies who will be forced to pay more to service their debt costs
Our high-quality “compounders” approach to stock selection should already benefit in such an environment as we naturally gravitate away from high-risk, highly leveraged stocks described in the aforementioned first and third bullets. And while we have owned high growth tech stocks described in the second bullet, we are unwilling to pay their current prices, and are happy to step aside until they grow into their valuations or until the market forces a valuation that is more sensible.
In late 2020, we reduced our exposure to highly valued megatech stocks, whose valuations are at multi-decade highs. Our focus remains on quality companies that can compound earnings over the long run, and smaller, neglected names trading at sensible valuations.
To read more about our equity impact and ESG investing process as well as our compounders approach to equity selection, read our latest perspective and watch our recent 5in5 video with Tom Lott, portfolio manager at CCM.