How Do Interest Rates Affect Stock Market Returns?

On this episode of The Long View, author and financial educator Brian Feroldi breaks down individual stock investing, how valuation plays a role, and how interest rates affect stock market returns.

Here are a few excerpts from Feroldi’s conversation with Morningstar’s Christine Benz and Amy Arnott.

The Role of Valuation in Buying Individual Stocks

Amy Arnott: You mentioned that some of your biggest personal mistakes have been selling too early. But what role do you think valuation should play in the process for buying individual stocks? And are there certain valuation metrics that you like to look at?

Brian Feroldi: Valuation is a really tricky thing for investors to understand and to wrap their heads around. Moreover, if you just think through what has happened at the geopolitical level or at the very macro level in the United States over the last 20 years, interest rates have a big impact on the way that stocks are valued. From 2009 all the way up until pretty much 2022, interest rates in the United States were effectively zero. And when the cost of borrowing is effectively zero, that can really warp the way that stocks should be valued. So, for me personally, from the period of 2009 until 2022, the lesson that the market taught investors was to deemphasize valuation. And when the interest rates were set at zero, that lesson came through loud and clear where the thing that mattered most was the quality of the business and growth of earnings, and the valuation you paid mattered less.

Now that we’re in a more normalized—and I put that in air quotes, “normalized”—interest-rate environment, interest rates have returned to near the historic norms, valuation has retaken its role as being a very important thing that investors should pay attention to. So, for many years, valuation was deemphasized as part of my investing process. Now with interest rates normalized, it is more emphasized. When it comes to valuing businesses, one of the biggest mistakes that I made historically was I didn’t use the right valuation metric at the right time. So, companies go through different phases in their growth cycle. There’s an early startup phase, there’s a high-growth phase, there’s a shareholder-return phase, and there’s a decline phase. And which valuation method you should use depends heavily on which stage the company is currently in. So, if a company is big and mature in the shareholder-return phase, it’s got a wide moat, I think very common valuation metrics, such as price/earnings ratio, price/free cash flow ratio—those metrics make a lot of sense for valuing companies in that stage. However, if a company is earlier in its development, you have to use very different metrics such as the price/sales ratio or the enterprise value/total addressable market ratio, or other simplified metrics simply because the company isn’t yet optimized for earnings. So again, a big mistake that I made early in my investing career, I didn’t understand that you should use different valuation tools at different times, but now I do.

How Do Interest Rates Affect Stock Market Returns?

Christine Benz: We have a lot more questions about valuation and you’ve written a lot about valuation, but I wanted to follow up on your comment about interest rates and their role in all of this. When growth stocks fell in 2022, that slide was widely ascribed to rising rates and the implications for growth companies’ distant cash flows. But more recently, some market watchers have argued that value companies, especially smaller companies, are more vulnerable to rising rates because they tend to be more highly leveraged, so they are most affected by higher rates. So, which of these narratives is correct when thinking about the role of interest rates in affecting stock market returns?

Feroldi: That’s an interesting question. And it’s generally a very tricky question. I think that both narratives do have elements of truth to them. If you think about companies that do have a lot of debt on their balance sheet that are very highly leveraged, in other words, those companies are clearly paying interest—they take a portion of their operating income and use it to pay off the interest that they have. Well, the higher interest rates go, the more that debt becomes a burden on those companies’ earnings because they have to use a bigger and bigger portion of their operating income simply to cover their interest payments. So, it makes sense to me that rising interest rates would really hurt those companies that aren’t very highly leveraged simply because their cost of capital was going up so dramatically.

On the flip side, when you think about very high-growth companies, companies that are, say, in the software-as-a-service space, growing 50% per year, a lot of those companies are valued very, very highly and a big portion of their current value is on the assumption that their growth will continue into the future and that a lot of their cash flows that they’re going to be generating are five, 10, 15 years out. So as interest rates rise, that causes the discount rate on those future cash flows to be raised. That in turn dramatically impacts the current price that investors should pay for those stocks given that the discount rate on those future cash flows has gone up. So, I would argue that rising interest rates have hit both companies, very highly valued stocks that have their cash flows in the future and companies that have high debt levels. So, it makes sense to me that both categories have seen their share prices decline given interest rates have gone higher.

Is Nvidia Cheap or Overvalued?

Arnott: Sticking with the theme of valuation, you recently made the case that Nvidia NVDA, in your opinion, isn’t terribly overvalued, although you’ve also conceded the stock might not be cheap, either. Can you run us through some of the key metrics that you would look at to make that assessment?

Feroldi: What has happened to Nvidia over the last two years has been nothing short of remarkable. I can’t remember the last time that a company that was already big—and Nvidia had a market cap that was over $100 billion—then went to dramatically, dramatically grow its revenue, its margins, and its profits so much that its stock price has just exploded. And meanwhile, the valuation on a trailing basis does look insanely expensive. However, if in the denominator of your multiples, you look at the forward price/earnings ratio for Nvidia, which incorporates that growth, that extreme growth into it, Nvidia might not be as expensive as it first appears on paper. So, this is why valuation can be so tricky and can trip up so many investors because many people, myself included, are taught from the get-go that price/earnings ratio is the ultimate measure of valuing a business. And if you look at Nvidia’s price/earnings ratio, just last year, it was over 100, even over 200, at some points during the year. And there’s no way that a rational person would look at that price/earnings ratio on a trailing basis over 200 and say, “Well, this stock is a buy.” That just defies conventional thinking.

However, if you bought Nvidia stock, even at those very high price/earnings ratios, you have earned multiples on your initial investment. The reason is the E, the earnings in that equation for Nvidia, has gone up far more on a percentage basis than the stock price has. This is a great example of why valuing companies can be so tricky and why using traditional valuation metrics, such as the price/earnings ratio, really has a ton of nuance to it. Because it’s not just the price/earnings ratio in absolute terms that you can use to determine if a company is cheap or expensive. It is the direction and magnitude of the increase or change in the company’s earnings that dictates where a stock price can head. Sometimes stocks can go up, their price can increase, and their valuation can be lower in the future simply because their earnings have gone up more.

The inverse is also true. Sometimes stocks can fall 50% and their stocks can be more expensive if their earnings are falling by more than 50% during that time. So, valuation is tricky in general, but valuing hypergrowth companies like Nvidia is particularly tricky, especially since the big question on investors’ minds, or at least mine is, is Nvidia’s earnings growth sustainable? Or are they riding a one-time boom that will inevitably result in a bust? I don’t know the answer to that question, which is why I’m not an Nvidia shareholder. But the point of this is, if you look beyond the traditional valuation metrics, Nvidia might not be as insanely priced as you think it is.

Growth Stocks Have Been Outperforming Value Investing

Benz: Speaking of Nvidia, it’s kind of the mother of all growth stocks, and growth stocks have outperformed value for an extended period, leaving some to question whether value-style investing is somehow fundamentally broken. What’s your take on that question, on the fact that we’ve had this narrow subset of winners and everything else has not been performing nearly so well?

Feroldi: I’ve been investing for 20 years, and during that time, I have seen investing styles and investing ideas go in and out of fashion. And if you look back at the data, even on a more historical basis, this seems to happen even at the macro level. So, during periods where US stocks have underperformed, international stocks have oftentimes shone through. And there have also been periods where growth stocks have outperformed, and value has been left behind. And the inverse has also been true.

If you just think about broadly what’s happened in the United States over the last 14 years, the place to be, the number-one place to invest pretty much in the world has been large-cap US stocks. Those stocks have rewarded investors hugely, both from a valuation perspective and more importantly from an earnings perspective. The earnings and the profits of the “Magnificent Seven” have just grown tremendously over the last 10 years and their stock prices have grown alongside them. And small-cap companies and value companies have largely been left behind. My hunch is that there will come a point when that does reverse itself, when big-cap companies or mega-cap companies start to trade at a discount to the market as investor sentiment leaves them, and that value stocks might have their time in the sun again.

But trying to figure out when that switch occurs, boy is that tricky. And it’s been brutal if you’ve been a value investor over the last 10-plus years because you have likely dramatically underperformed the S&P 500 over that time. This is why there’s that great saying the market can stay irrational longer than you can stay solvent. Can you imagine being a small-cap value money manager over the last 15 years and trying to tell your investors, “Yes, invest with us. Yes, we’ve underperformed for 15 years, but that turnaround is on the horizon.” This is why investing by style can just be so brutally hard.