Central banks around the world are embarking on an interest rate-cutting cycle.
But what does this mean for growth and value companies, and where could the opportunities be?
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios also shouldn’t be looked at on their own and past performance isn’t a guide to the future.
How do rate cuts affect growth and value investing?
Central banks, like the Bank of England and Federal Reserve, cut interest rates to stimulate the economy, making borrowing cheaper for businesses and consumers, which can encourage spending and investment.
Lower rates also reduce loan costs and can boost stock prices, as companies can grow more easily with cheaper access to funds.
On the flip side, lower rates tend to feed inflation, which means that cutting too deep could actually harm the economy.
In theory, rate cuts should benefit both investment styles.
As rates fall, expected future profits become more valuable, which boosts company valuations.
But there are some more specific ways each style is impacted by lower rates.
Growth
Growth stocks are typically companies expected to grow profits and cash flows faster than the market.
This means falling rates can have a much larger positive impact on the value of future cash flows relative to value companies.
As a result, growth companies typically have higher valuations (think high price-to-earnings ratio) than the broader market. But these higher valuations do increase the investment risk if profit growth fails to materialise.
Value
Value stocks are typically companies with lower valuations (think low price-to-earnings ratio) than the broader market.
This can often be due to low rates of expected future growth, market pessimism or operating in a cyclical industry at the bottom of the cycle.
Lower interest rates can lead to an uptick in broader economic activity, which can boost consumer spending and increase revenues and profits for these companies.
An uptick in economic activity can also lift future profit expectations and investor confidence.
All of these factors can lead to higher valuations.
Are rate cuts better for growth or value?
In the relatively recent past, growth stocks have outperformed their value peers.
Looking forward, a prolonged period of lower rates should provide growth stocks with a comparatively stronger tailwind.
However, growth companies also tend to carry more risk, largely due to lofty growth expectations that might not materialise.
Where are we now?
Since rates peaked, we’ve had two rate cuts.
That means the rate cutting cycle is underway, which should favour growth stocks.
But if 2024 has taught us anything, it’s that expectations can change.
At the start of 2024, markets were pencilling in six interest rate cuts throughout the whole year. Fast-forward to November, and there can only be a maximum of three rate cuts this year.
This shows that markets can get it wrong sometimes too. It’s not clear how long the current cycle will last, or how fast cuts will come through.
As ever, this just highlights the importance of a diversified portfolio, as this way you will likely always have something working in your favour.
Here are three share ideas across both styles – as ever we’ve focused on quality businesses with strong long-term prospects.
Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.
Growth share idea – Palantir
If interest rate cuts come through as expected, growth companies look set to be among the biggest beneficiaries.
In terms of growth, Palantir’s rise has been phenomenal. The group was founded in 2003 and has already risen to be one of the 80 largest companies in the US.
Palantir helps government agencies and companies make sense of large, complex data sets, which in turn supports smarter decision-making. In our increasingly data-driven world, these solutions have become incredibly valuable.
Palantir's platforms are already well-established in industries like national security, healthcare, and financial services.
In the artificial intelligence (AI) landscape, data reigns supreme. The more data you have, the more powerful AI can be. Demand for Palantir's AI-powered solutions is rising as more businesses seek to tap into its capabilities – a trend we expect to continue.
Palantir's growth potential is closely tied to expanding its customer base while navigating the regulatory challenges of data usage.
As a software name, its earnings are high quality. There’s plenty of cash to back up its accounting profits and it doesn’t need to spend loads to generate revenue.
The company turned its first profit in 2023, though it’s been free cash flow positive since 2021. We don’t think the lack of long-term profit history is a major issue – it’s a relatively young business and investment in expanding the product range and market reach has been a priority.
However, this focus does add some risk if current investments don’t pan out.
Perhaps the biggest risk to short-term performance is around expectations. The valuation is lofty, and analysts have been upgrading profit estimates after a good run of results recently, leaving little room for missteps.
Value share idea – NatWest
If interest rate cuts come through slower than expected and rates stay higher for longer, some value names might also fare well.
Value stocks can often come with superior dividend yields, which can be attractive for income investors.
UK bank NatWest could tick both these boxes. Its recent third-quarter results beat expectations, and conditions for UK banks look promising.
As a traditional lender, it makes money by lending at higher rates than it pays on deposits. When rates fall, the spread between the two rates often gets squeezed, which can put downward pressure on profits in the short term.
So, if rate cuts come through slowly, the impact on profits is softened.
Loan default rates are an important risk to watch for. So far, so good on this front – a trend that’s largely been echoed across the sector.
There's also the benefit of the structural hedge – think of this as a bond portfolio that's set to roll on to better rates over the coming years.
NatWest is rolling off some of the lowest rates in the sector, and should be one of the biggest beneficiaries. A fact that still seems underappreciated by the market.
Savers looking for longer-term accounts have acted as a drag for several quarters. Those higher-rate accounts essentially cost more for NatWest to run. But we’re seeing those trends now stabilise, which is good for margins.
Costs are a challenge and key focus.
There’s been progress on this front. But medium-term targets look for a sub-50% cost-income ratio, but we don’t expect that to come any time soon.
NatWest looks well-placed to benefit from several sector tailwinds.
A strong balance sheet supports the 5.1% dividend yield, plus the potential for buybacks. Remember though, yields are variable and no returns are ever guaranteed.
Despite still trading below book value, the valuation isn’t as attractive as it was at the start of the year.
The author holds shares in NatWest.
Balance of growth and value share idea – AstraZeneca
Sitting in the middle ground of value and growth is AstraZeneca, the UK’s largest pharmaceutical company.
It’s less sensitive to economic cycles than your typical growth company, as demand for healthcare tends to remain stable regardless of market conditions.
Astra makes money from developing and selling essential medicines, making its income stream relatively robust. But there are some growth opportunities mixed in too.
Cancer treatments are a cornerstone of the group’s offering, currently accounting for around a third of sales. These drugs can often maintain high growth levels for many years as patient access improves, approvals are gained in new markets, and clinical trials prove their efficacy in additional diseases.
There’s also a diverse late-stage pipeline of new products, meaning there could be more growth drivers ahead.
Astra’s had an impressive hit rate in the past and some emerging treatments have the potential to be transformational.
Its focus on next-generation therapies could revolutionise cancer treatment, with the potential to replace chemotherapy and radiotherapy in certain cases.
But this route to growth comes with drawbacks.
Research and development of new drugs is expensive, and there are no guarantees of success. The process is lengthy, and many drugs are tossed aside and never make it to market, so it’s important to take a long-term view.
Net debt is at a comfortable level, and cash flows from its existing portfolio of medicines is strong. This helps support the prospective 2.6% dividend yield. As always though, shareholder returns aren’t guaranteed.
The valuation’s come down significantly in recent months, largely due to a marketing investigation in China. While the extent of any damage remains unknown, we think this is an overreaction and view the valuation as attractive given that the underlying business performance looks good.
However, potential investors should take a long-term view, and expect ups and downs along the way.
This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Investments rise and fall in value so investors could make a loss.
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