Big Tech Stocks Thrive Amid Rising Interest Rates
In a surprising turn of events, Big Tech stocks have been defying expectations by thriving as interest rates rise. Typically, these two factors wouldn’t go hand in hand, but smart debt management strategies adopted by these companies have been instrumental in their success.
This year, the 10-year Treasury yield has climbed to nearly 4.3% from just under 3.9% at the end of 2022. With the Federal Reserve’s focus on combating inflation, the market anticipates higher long-dated bond yields. This poses a challenge for Big Tech companies as it devalues their future cash flows, and these companies are largely valued based on the assumption that a substantial portion of their profits will be realized in the distant future. Consequently, this lowers their price-to-earnings (P/E) ratio. Historically, such a scenario would negatively impact tech stocks.
However, recent trends have contradicted these historical patterns. The Nasdaq 100, which prominently features tech giants like Apple, Alphabet, Nvidia, Microsoft, and others, has witnessed a 43% surge this year. This uptick can be attributed, at least in part, to the increasing multiple of expected earnings per share for the upcoming year. According to FactSet, the index’s P/E ratio has risen from just under 23 times at the beginning of the year to approximately 24.5 times. The growth outlook for Big Tech firms has been bolstered by advancements in artificial intelligence, particularly in cloud and chip sales.
Traditionally, higher bond yields have resulted in declining tech P/E ratios. For instance, in October 2022, when the 10-year yield reached 4.2%, the Nasdaq 100 traded at below 20 times its earnings. However, the current scenario showcases a departure from this pattern, with tech valuations remaining largely unaffected by even higher yields.
One significant reason behind this resilience is the sound management of debts by Big Tech companies, coupled with their increasing profitability. These companies have capitalized on low interest rates in 2020 by refinancing existing debts and locking in new borrowings. This proactive approach is evident in the extended average maturity for the debt of growth companies on the S&P 500, primarily constituted by Big Tech. According to Citi, the average maturity increased to 12 years in the second half of 2020 from approximately 10.5 years just months prior. Essentially, these companies embarked on a refinancing spree during a period of lower interest rates.
Consequently, these measures have enabled Big Tech companies to lower their overall rates. The average yield for S&P 500 growth companies currently stands at around 3%, down from nearly 3.5% in early 2020, before the borrowing surge. This reduction in borrowing costs has had a positive impact on equity valuations. These companies are now perceived as having a higher capacity to repay their debts, hence being more credit-worthy. This, in turn, indicates the potential for more cash to flow to equity holders’ bottom lines, thereby raising the price investors are willing to pay for these stocks.
What sets these companies apart is their ability to secure low rates, driven by their increasing profitability. In other words, their profit growth has outpaced their debt accumulation, resulting in an increase in their equity values.
Netflix serves as a prime example of this phenomenon. In 2019, the streaming giant’s net debt (debt minus cash) amounted to slightly under $10 billion, equivalent to just over three times its earnings before interest, tax, depreciation, and amortization (EBITDA) for that year. Despite raising $1 billion of debt in 2020, Netflix’s net debt currently stands at less than $7 billion, which is lower than its anticipated EBITDA of slightly above $7 billion this year.
The ability of these tech companies to effectively manage their debts has shielded their stocks from the adverse impact of rising 10-year yields.
In conclusion, Big Tech stocks have displayed remarkable resilience in the face of increasing interest rates. Through prudent debt management practices and burgeoning profitability, these companies have not only reduced their borrowing costs but also strengthened their equity valuations. Their ability to secure low interest rates has been fueled by their improving financial performance. By meticulously navigating the challenges posed by rising bond yields, Big Tech firms have managed to carve a unique path characterized by continued growth and attractiveness to investors.
