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1/ The convexity of growth multiples relative to the compression of the the 10yr is something worth understanding, as it contextualizes the rise of GARPy stocks (think 3ish% FCF yield, 20% FCF CAGR stocks) in the last 5 years.
2/ Using rough numbers/estimates to explain my point. Let’s say GARP trades at a 200bps premium to the 10yr and value at 500bps. When the 10yr is at 2.5%, you get 4.5% FCF yield on GARP and 7.5% on value.
3/ Now let’s say the 10yr goes down to 1%. Under our old premium assumptions, GARP should trade at 3% FCF yield and value at 6%. While the absolute bps yield change is small, the impact on multiple for GARP is instrumental.
4/ This correlates to 50% multiple expansion for GARP (going from ~20 PE to 30 PE) vs. 25% for value. This is what I refer to by the convexity. As this multiple gets higher/FCF yield goes lower, the effect on multiples accelerates. This is EXACTLY what has happened...
5/ ...over the last 4-5 years. Go look at a chart of FCF yield for $MA $V $MSFT $CSU.TO (and all our favorite compounders). Not to say they aren’t all incredible businesses, but the multiple expansion on the way here represents an equal and opposite risk if rates were to rise.
6/ This idea of convexity contextualizes the returns we’ve seen, but prepares us for the future. Who knows what rates will do (if I knew, I’d be a billionaire). But if they go up, we will see a bloodbath in these high quality names as their multiples begin to drop. Good luck all.
