A low interest rate environment makes growth stocks the only ones worth researching.
Professional investors, wealth managers, and commentators have been expressing concerns about the decline of value stocks, as they have underperformed growth stocks significantly over the past decade.
In light of this underperformance, a closer examination is necessary to determine whether fundamental investors should continue to focus on value stocks or shift their attention to other investment opportunities.
To assess the potential profitability of value investing in different interest rate environments, we conducted a study to model the profits an investor could make by identifying market mis-estimations in various aspects of a stock’s valuation.
We utilized a discounted cash flow (DCF) model to determine stock value under different scenarios, considering factors such as interest rate, growth rate in dividends, dividends, and terminal value of the firm.
Our analysis sought to understand where an investor’s focus could be most lucratively directed based on different rate environments. Specifically, we explored the potential returns of finding a market mis-estimation in the growth rate of dividends, the terminal value of the company, and the current dividend paid.
The results of our study indicated that researching a mis-estimation in the growth rate of dividends yielded the highest profitability for investors in low interest rate environments. As the federal funds rate increased, the potential returns from this approach declined.
Similarly, perturbing the terminal value of the company by 10% resulted in significant returns for investors, particularly in low-rate environments. However, in longer horizon models, returns diminished more steeply as the federal funds rate increased.
On the other hand, analyzing the current dividend paid by a company proved to be most profitable in high interest rate environments.
In conclusion, our study suggests that in a near-zero interest rate environment, investors should focus on companies with high terminal values and substantial growth rates in their earnings/dividends, i.e., growth stocks. Conversely, in a high interest rate environment, investors would be better off targeting the true current dividend paid by a firm, signaling a shift towards value stocks.
With US Federal Reserve chair Jerome Powell’s recent statement indicating no plans to raise rates in the near future, fundamental investors in the current low interest rate environment should concentrate on researching and trading growth stocks to maximize their profits.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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### Key Points
– Value stocks have underperformed growth stocks over the past decade.
– Researching a mis-estimation in the growth rate of dividends yields the highest profitability for investors in low interest rate environments.
– Analyzing the current dividend paid by a company is most profitable in high interest rate environments.
– Fundamental investors in the current low interest rate environment should concentrate on researching and trading growth stocks to maximize their profits.
