Markets got off to a shaky start to kick off the new year. While the major indexes posted weekly losses, the economically sensitive Dow Jones Industrial Average was the relative outperformer, as investors positioned themselves for a year in which the Federal Reserve is expected to raise rates and reduce the size of its balance sheet (i.e quantitative tightening). In line with the increased focus on rising rates, the tech-heavy Nasdaq Composite was the relative laggard, now more than 7% off the all-time high reached in November.

We were not that surprised by the action and here's when we say "I told you so." It was in line with our view that in 2022 you want to own reasonably-valued, earning-money with demonstrable-growth companies while avoiding the high-valuation, future-earning story stocks with no earnings.

Ultimately, the performance of the no-earning stocks versus the value names, or the divergence thereof, will prove us correct. However, we realize that we have been telling you not to own the no-earning stocks, without specifically explaining to you why. In today's post, we will give you a detailed explanation of why in the coming years, you want to avoid stocks with no earnings. 

Why do you own stocks? 

You have to step back and ask yourself a question, "Why do you own stocks?" Sure you can say "because you like the company" and there is nothing wrong with that. But if you want to make money, which is what we're trying to do here for ourselves and hopefully for you, the key to keep in mind is you own shares of a company because of how much money the company is making and will be able to make. Most often, stocks are valued on future earnings and cash flows. Investors model a present value for companies by estimating the future numbers and then discounting them to the present day using a discounted cash flow (DCF) model. 

When the cost of money is zero (i.e when rates are at zero), the discount rate (the denominator in a DCF model) is minimal and as a result, investors can speculate and look out into the future as far as they want — because the value in the future is essentially the same as today’s. 

However when money starts getting expensive (i.e when interest rates rise), the discount rate (or the rate of return investors require for the risk they are taking on by owning equities) must increase. That increased denominator means that the present value of future earnings and cash flows declines. The further out those earnings are, the less they are worth today with every tick higher in rates.

An example of how rising rates impact valuations 

To better illustrate this, let’s consider an example of how a higher discount rate impacts future earnings.

Company A is a high-flying tech stock with a promise about the future but no earnings power today, making it a longer duration asset (think an electric vehicle company like Rivian that has produced only a handful of cars, losing tons of money). Company B is a value/cyclical name, like a Ford which earned ~$11 billions EBITDA in 2021, traditionally thought of as a short-duration asset.

Company A is expected to generate $10 of earnings per share in 2027 (five years from now), while Company B is expected to make $10 per share by the end of 2022 (note: these are not real numbers for Rivian and Ford). An increase in rates means that Company A’s earnings are discounted back to the present five full years at a higher rate, while Company B’s must only be discounted back one year at that higher rate.

When rates are on the rise, the impact of discounting to the present day has a larger and larger effect the more years you have to do it. This causes investors to seek out shorter duration assets like Company B over stocks like Company A. 

Ultimately, A and B will both generate $10 in earnings. However, the present value of company B’s $10 in earnings is worth increasingly more relative to company A’s as rates rise. That is why we want to own the stocks of companies that generate real profits today. The closer those profits are to the present day, the less impact rising rates have on their present values, making those earnings more attractive compared with those of the high-fliers that see their present-day intrinsic values drop on higher rates.

Bottom Line: We're not saying that you should own only value and avoid growth stocks, we simply are explaining why growth stocks are being punished in the current environment despite no changes in their fundamentals. You also have to keep in mind that not all "growth" stocks are the same, and that is our stance moving forward on how the stock market will favorably treat the demonstrable, real-earning growth names like Microsoft (MSFT), Apple (AAPL) and Advanced Micro Devices (AMD), versus hating the no-earning, concept-story names like Rivian (RIVN) or Virgin Galactic (SPCE). We've always maintain a strong stance on keeping a balanced approach, between the "growth-at-a-reasonable-price" and the "value/cyclical" names.