Interest rates and IR: What a rate reduction might mean for growth vs value stocks

‘Our initial hypothesis was that growth stocks would outperform, as investors gravitate to risk-on assets following the 2022 bear market,’ says Alex Lustig of his new research into the potential impact of anticipated interest rate cuts. ‘The rationale behind this lies in the belief that lower interest rates amplify present valuations of growth companies, whose long-term growth prospects become more attractive due to discounted future cash flows.’

His new research – based on historical stock returns in the US from 1982 to 2023 to evaluate the impact of sudden interest rate cuts on equity performance – finds that growth equity outperforms value, but this outperformance depends on how fast rates drop, with a reduction of more than 5 percent necessary to influence growth stocks in the US market.

Lustig is senior client consultant at Style Analytics, part of Confluence, and author of Factors and falling interest rates. ‘Our findings indicate a significant correlation between long-term interest rates and the performance of value vs growth stocks, particularly when observing the monthly fluctuations in rates,’ he explains when asked if the research threw up any surprises.

‘Therefore, we expected a similar magnitude of relative performance with growth stocks when rates decrease, but the dynamics differ. While value typically outperforms by approximately 100 basis points (or 1 percent) when rates rise by 10 percent in a given month, the relationship is more than twice as impactful with growth stocks and decreasing rates.

‘For this relationship to hold, however, long-term rates must decline by at least 5 percent. Subsequently, each additional 10 percent decrease in rates results in growth stocks outperforming by approximately 220 basis points – roughly twice the outperformance observed with value when rates increase.’

He adds that the pace of rate decreases necessary for growth outperformance is higher than that required for value outperformance (15 percent and 10 percent, respectively) – a trend Lustig puts down to ‘the heightened volatility inherent in growth stocks compared with their value counterparts’.

Blurred lines and the evolution of fundamental metrics

Across the four decades covered by the research, Lustig points out that the fundamentals of what makes a quality or growth stock in equity research have shifted. ‘Metrics like return on equity (ROE), return on invested capital (ROIC) and return on assets (ROA), once indicative of growth, now blur the lines with quality metrics,’ he says.

Delving deeper into this, his team identified specific fundamentals that drive outperformance. Lustig says that within quality, ‘the gross profits-to-assets subfactor emerged as the primary driver, yielding a weighted average relative market return of more than 9 percent across the historical periods marked by decreasing rates’, while two metrics traditionally associated with growth – ROA and ROIC – ‘also exhibited strong performance, with weighted average relative market returns of approximately 7 percent each’.

He further points to the surge in performance amid ‘the loose monetary policy enacted up to the Covid-19 pandemic’, which he describes as an ‘influential’ data point. ‘This instance of growth outperformance stands out from typical trends, highlighting the extraordinary circumstances of the time,’ he says.

The lesson for investor relations

Prioritizing metrics like the gross profits-to-assets ratio, ROA, ROIC and net-profit margin (more so than gross-profit margin) is more impactful to long-term price appreciation than ROE, sales/earnings growth stability and low accruals, says Lustig, talking about how his research can benefit IR teams.

‘Focusing on marketing metrics such as a favorable gross profits-to-assets ratio, ROA or ROIC holds appeal for both quality and growth-style investors,’ he concludes. ‘These fundamental metrics are pivotal in driving stock returns and fundamental investors use these metrics to screen potential investments effectively.

‘Emphasizing these metrics can attract a diverse range of investors, highlighting their favorable attributes not only in recessionary periods but also in end-cycle market environments.’