Rising interest rates have impacted all stocks, but many growth stocks have been hit since the aggressive rate cycle started in 2022. Why?
The cost of capital is rising for growth stocks
There are several reasons for this. Firstly, as interest rates increase, the cost of capital for a business rapidly rises. Access to cheap debt to fund growth initiatives becomes constrained. Likewise, market activity tends to slow, so issuing equity to finance growth becomes more challenging.
For stocks with a lot of debt, rising interest rates can increase debt expenses. That can rapidly eat into earnings.
The economy will slow
Secondly, high interest rates tend to slow the growth of the economy. Consumers slow spending, and businesses become more measured in how they invest. As a result, earnings growth tends to stabilize or even decline in a higher-rate environment.
Valuations are adjusting
Thirdly, stock valuations tend to have an inverse relationship to interest rates. Interest rates go up, the rate of growth tends to come down, and the discount rate applied to valuations goes up.
That means the long-term value of a stock must come down.
Basically, interest rates have a very strong ability to slow the profitability, momentum, and valuation of a growth stock. While this might be true on a market and theoretic basis, it is not always true on an individual stock and practical basis.
Descartes: A stable growth stock with an excellent balance sheet
For example, Descartes Systems (TSX:DSG) has been one of Canada’s steadiest growth stocks. On a five-year basis, this growth stock is up 147% (a 20% CAGR, or compound annual growth rate). On a 10-year basis, Descartes stock is up 730% (23.5% CAGR).
While rates are up significantly, this stock has delivered a 7% return this year. It has held its own. Descartes operates the leading digital transportation and logistics network around the world. It complements this with an array of software services specially catered to the transport industry.
Despite worries about the global geopolitical situation, this company actually does better in times of uncertainty. Political, border, and shipping complexity draw customers to its platform.
91% of its revenues are recurring, and it earns extremely high (20%) profit margins. The company is a cash machine. This year, it has earned just around $50 million per quarter of excess spare cash.
As a result, this growth stock has an exceptional balance sheet. It has no debt and about $230 million of cash. That is even after several acquisitions (including a large one) in 2023.
Descartes could actually benefit long-term from a weakening economy. As tech valuations continue to come down, it can use its strong cash position to add very accretive businesses into its portfolio.
Now, Descartes is not the fastest-growing company. However, it has a target to grow steadily at a mid-teens pace. For its high-quality business, investors do need to pay a premium.
It trades with a forward price-to-earnings ratio of 49 and a price-to-free cash flow ratio of 27. Its enterprise value-to-EBITDA (earnings before interest, tax, depreciation, and amortization) is 23 times. By no means are these valuation metrics cheap. However, it may be some consolation that the EV/EBITDA is below its five-year average.
The Foolish takeaway
Growth stocks like Descartes are almost never cheap. However, its hardy business, strong balance sheet, and stable growth should give it the resilience to outlast this interest rate cycle. Choose strong compounders, and you can stand to do very well over the longer term.
