As we anticipate a gradual increase in interest rates over the next several years, we want to examine the differences in growth vs. value stocks and what historical performance of each type could tell us about the environment we may be heading into. Growth companies are considered to have a good chance for considerable expansion over the next few years, either because they have a product or line of products that are expected to sell well or because they appear to be run better than many of their competitors and are thus predicted to gain an edge on them in their market. A few well-known growth companies are Google, Tesla, Microsoft, Nvidia, and Amazon.
A value stock trades at a value that appears to be lower than its fundamentals would indicate. Value stocks are most likely mature companies with a stable dividend issuance, revenues and earnings that are temporarily experiencing adverse events. Common characteristics of value stocks include a high dividend yield, and a low P/E ratio. A few well-known value companies are Berkshire Hathaway, Procter & Gamble and Johnson & Johnson.
Now let’s look at what history shows about growth and value stocks during rising interest rate environments. The interest rate we are talking about here is the federal funds rate. The federal funds rate is the rate at which depository institutions borrow from and lend to each other overnight. When the Federal Reserve acts to increase the rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy. Growth companies leverage borrowing to continue growth and so when borrowing becomes more expensive to have consistent profits, growth needs to make up for it. Value stocks on the other hand do not rely as heavily on borrowing and therefore their stock value is not as impacted by rising rates. Looking at historical data, during periods of rising interest rates, we see value stocks typically outperforming growth stocks.
Our portfolios are built with exposure to different asset types in mind so exposure to both growth and value is achieved. As always, we will continue to monitor and adjust exposures when economic data warrants it. This rising interest rate environment is something we will be keeping a close eye on in the coming months.