All These Rate Hikes Are Bad For Growth Stocks – Until They’re Not

Reda Farran

about 2 months ago3:00 mins

All These Rate Hikes Are Bad For Growth Stocks – Until They’re Not

The entire US stock market has plummeted this year, but growth stocks’ collapse is especially noticeable: the fast-growing investor darlings have seen their valuations wiped out as the Fed embarks on its most aggressive rate hiking campaign in decades. But if all these rate hikes push the US economy into a recession, that’s a backdrop that could actually work out very well for growth stocks – if you can identify which ones…

Why would growth stocks do well in a recession?

First, the relative appeal of growth stocks changes for the better during a recession, when most other companies see their earnings shrink or stagnate. Put differently, when growth is scarce, investors flock to the few companies that can still expand their earnings – in other words, growth stocks.

Second, when the US economy enters recession, the Fed typically pauses or even reverses some of its previous rate hikes. That benefits growth stocks, whose valuations are more sensitive to interest rate changes. In today’s scenario, at worst, the Fed would pause rate hikes, removing the valuation headwinds facing growth stocks this year. At best, it would cut rates, delivering an outsized valuation tailwind to growth stocks.

What’s the opportunity here?

We’re not officially in a recession, and there’s no need to jump the gun and start buying now. But what you can start doing is your homework: identify attractive growth stocks to add to your watchlist – basically, companies that are most likely to outperform if there is a recession. I’d suggest looking for these three criteria:

1. The company is profitable.

Unprofitable companies with high revenue growth tend to see their losses balloon during a recession. That forces many of them to either sell new shares at depressed prices or raise large amounts of debt – both of which are bad for shareholders. For that reason, I recommend that you focus only on companies that actually make money, with high profit margins and fast earnings-per-share (EPS) growth. These companies are more resilient during downturns: you can think of them as “defensive growth” stocks.

2. The stock is attractively priced.

While you do want to buy into stocks that are expanding their EPS, you don’t want to overpay for that growth. Expensive-looking growth stocks can be a disaster when their prospects fail to meet investor expectations, as was recently the case with Netflix. And let’s face it, there’s more potential to disappoint on growth during a recession. So when searching for growth stocks, look for ones that are attractively priced. One way to do that is to screen stocks with low PEG ratios (P/E divided by the earnings growth rate). Online investing tool FINVIZ can help with that: it allows you to screen on many stock criteria, including PEG.

3. The company can still grow its earnings during a recession.

Remember, when wider economic growth is scarce (or negative), investors flock to the few companies that can still expand their earnings. So your job is to find companies that can still grow their earnings during a recession.

A company could, for example, be benefitting from some wider thematic trend that’s not impacted by a recession – like a wind or solar company in a place with ambitious renewable targets. Or a company could have strong pricing power and be selling products people need, even during bad times – like a biotech firm with life-saving products in an industry with few competitors.

There are plenty of other examples, but the underlying idea is the same: look for something about the company, the products it sells, or the environment that it operates in that will allow it to continue to expand its earnings, even during economic downturns.

Remember, economic conditions can shift quickly. So doing your homework now will put you in a strong position, ready to adjust your portfolio when the time comes.

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