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Bargains Are Not Always What They Appear to Be

• “High Growth/No Profit” firms appear to have benefitted from a low interest rate/low discount rate environment.

• A rising rate environment creates potential headwinds for “High Growth/No Profit” firms as distant future profits are discounted at the discount rate, where higher discount rates lower the present value of the future cash flows.

Avid readers will remember our previous articles “Return on Capital vs. Growth: Valuation as Interest Rates Increase” and “That Isn’t Flying, That’s Falling in Style” detailing the risks of high growth/no profit stocks in a potential rising interest rate environment.

Now that many of these pandemic winning stocks are down considerably over the past few months, it may feel like a smart time to load up. Consider the chart below which illustrates a -30% return of a High Growth/No Profit Index over the past 12 months.

20220308-chart-1After all, many of these stocks are the companies of the future and may seem like bargains. But before we make any brash decisions, we may want to consider the potential impact of higher interest rates on High Growth/No Profit companies. While we cannot predict future policy changes, it does appear that monetary policy is in a tightening phase with some likelihood of quantitative easing reductions and potential for rate hikes on the horizon.

With low or falling interest rates, future cash flows are typically worth more as investors generally are willing to pay up for more distant profits. As interest rates appear to be rising, the script has flipped - future profits are generally worth less, valuations appear to be responding in kind, and there is a typically a negative compounding effect to valuations. Thus, while relative valuations may appear attractive, we are comparing two different interest rate environments – low or falling rates vs potential for rising rates.

In a low or falling interest rate environment, High Growth/No Profit companies generally fund their operations by selling equity shares. Investors are attracted to these companies as low rates have relatively little impact on distant profits, which make up a bulk of the valuation of these firms. In a rising rate environment, these companies may still need to sell shares to fund operations. However, rising rates may significantly discount future profits as well as the firm’s valuation, which may limit potential investor appeal for both new and existing shares.

Our current inflationary environment can create upward pressure on interest rates because bond investors may only tolerate negative real rates for so long before they sell their positions, which can cause rates on bonds to rise. Pair this with the Fed’s plan to unwind its balance sheet and begin selling its own bond holdings (the Fed holds approximately 30%+ of both the treasury and MBS market)1 and we have the potential for a persistent rising rate environment.

Just as short duration bonds, which have near term cash flows which are less impacted by discount rates, generally outperform long duration bonds, which have more distant cash flows which are more heavily impacted by discount rates, in a rising rate environment, a similar case can be made for equities and their related cash flows. In a rising rate environment, investors will generally prefer stocks with valuations largely built upon nearer term value vs more distant profits in the future.

Over the past decade, we have grown accustomed to companies with significant growth and potential, above all else. With the potential for a rising rate environment, value-oriented strategies and commodities-based companies are positioned for potential outperformance, and if rates continue to rise, this could continue for some time.

As for the high growth/no profit companies that seem like bargains, don’t forget the old adage that if you buy a stock that’s down 80% and it finishes down 90%, you will be down 50%.

Important Disclosures & Definitions

An investor should consider the investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus containing this and other information, call 1-866-759-5679 or visit www.alpsfunds.com. Read the prospectus carefully before investing.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

All investments are subject to risks, including the loss of money and the possible loss of the entire principal amount invested. Additional information regarding the risks of this investment is available in the prospectus.

1 Source: St. Louis Fed, as of 02/28/2022

Book Value: the net value (assets minus liabilities) of a firm's assets found on its balance sheet.

Cash Flow: the net balance (inflows minus outflows) of cash moving into and out of a business at a specific point in time.

Discount Rate: the rate of return used to discount future cash flows back to their present value.

Duration: a measure of the weighted average term to maturity of a bond’s expected cash flows. Duration also represents the approximate percentage change that the price of a bond would experience for a 1% change in yield. For example: the price of a bond with a duration of 5 years would change approximately 5% for a 1% change in yield. The price of a bond with a duration of 10 years would be expected to decline by approximately 10% if its yield was to rise by +1%. Bond yields tend to fluctuate in response to changes in market levels of interest rates. Generally, if interest rates rise, a bond’s yield will also rise in response; the duration of the bond will determine how much the price of the bond will change in response to the change in yield.

Present Value: the current value of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.

Quantitative Easing: a monetary policy strategy used by central banks where they purchase securities in an attempt to reduce interest rates, increase the supply of money and drive more lending to consumers and businesses.

Short Duration Bond: generally, a bond with maturity of less than five years.

Bloomberg US 3000 Index: a float market-cap-weighted benchmark of the 3000 most highly capitalized US companies. One may not invest directly in an index.

Distributed by ALPS Portfolio Solutions Distributor, Inc.

APS001919 04/30/2023

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