It didn’t take long to see headlines about another technology sector sell-off feed through the market. It seems like a monthly occurrence that the threat of higher bond yields sends the technology sector into free fall.
The most common explanation any time that bond rates increase, and the tech-dominated Nasdaq or S&P500 fall, is that higher bond yields immediately devalue the future cash flows of technology-focused businesses. An issue, the pundits say, that is exacerbated by the fact that the majority of the profits, for most technology companies, are well into the future.
Naturally, the most positive trade for equity investors, whom we must remember are required to always be invested into equity markets, is to switch from comparatively expensive tech into cheaper, cyclical winners like commodities. But are they giving up too much in terms of quality?
Award-winning growth equity manager Hyperion has published a number of white papers on the issue, highlighting the important difference between high-quality and low-quality businesses. In its view, the former are much more able to handle inflation, and interest rate risk, better than most other investments.
Hyperion’s view is quite simply that high-quality investments are the key to sustained, long-term performance. The paper highlights the many reasons behind the seemingly higher short-term valuations applies to companies with sustainable businesses models (think Microsoft (NYSE:MSFT)), noting that “all other things being equal, longer-duration assets, including stocks, tend to be more sensitive to changes in long-term bond yields and discount rates.”
But the manager has one major caveat, being that this perceived ‘duration risk’ is only valid or relevant if the company’s growth in future free cash flow doesn’t change to match the expected increase in bond yields. As we know, investing in equities isn’t linear like investing in bonds. If you hold a bond and the prevailing yield increases, you know you are losing money.
Equities on the other hand, at least good-quality ones, have the ability to adjust in many ways, ranging from gaining market share to passing costs onto consumers; an issue regularly forgotten by short-term traders.
Hyperion offers a simple example:
“If the long-term expectation regarding nominal GDP growth increases by 1% (assuming this increase in economic growth is reflected in a 1% increase in long-term government bond yields) and the expectation for growth in future free cash flows also increases by 1%, then the present value of the stock should remain unchanged.”
The most important issue, and the central part of its approach, is in identifying high-quality, sustainable businesses with the ability to compound, as companies that cannot pass on inflation-related costs aren’t able to offset the impact of higher discount rates on their valuation.
Technology companies aren’t alone, as some resource and materials stocks can have high levels of sensitivity to changes in GDP. This means that their earnings can increase enough to offset higher rates, solely because the economy is growing.
Ultimately, whether you are a long-duration business or not, without pricing power, “you will be more sensitive to any one-off changes in discount rates,” says Hyperion, such as the environment we are experiencing now. This is likely a key reason behind the popularity of the “buy the dip” approach whenever sell-offs occur in the tech-heavy US markets.
As much as we would all like to see a global economy growing above trend, and the widespread profit growth that comes with it, it is abundantly clear this is not coming anytime soon. In fact, it hasn’t been seen since before the GFC. As the world stares down another period of below-trend growth “high-quality, structural-growth businesses are significantly more valuable,” the paper concludes.