Growth Stocks vs. Inflation: How Inflation Affects Growth
Growth stocks can represent some of the most exciting investment opportunities out there. This is because these young companies create an opportunity for outsized returns. Buying a reputable growth stock today could be like buying Amazon stock back in 2005. There’s just one problem. Right now, we are also in the midst of record-high inflation. Traditionally, inflationary environments are a bad time to buy growth stocks. So what should you do? Let’s compare growth stocks vs. inflation, examine the current inflationary environment and discuss how you can navigate it to invest wisely.
What Is a Growth Stock?
A growth stock is a share in a company that is poised to grow significantly faster than the overall market. Usually, these are young, exciting companies such as Airbnb, Uber, or Dutch Bros. Growth stocks typically have rapidly growing revenues, are unprofitable, and invest all their income into growing their business.
Here are a few common takeaways of investing in growth stocks:
- Price appreciation: Investors buy growth stocks in hopes that their share price will increase at a rate faster than the S&P 500.
- Richly valued: Analysts value growth stocks at many multiples of their earnings. This valuation is based on the company’s projected future earnings.
- No dividends: High-growth companies prefer to invest money back into their business instead of paying dividends.
Growth stocks also typically rely on outside funding from investors. Since they are so young, they do not have large cash piles. Instead, they rely on venture capital, investment banks, or other investors to grow their business.
Now, let’s examine inflation and how it can impact growth stocks.
How Does Inflation Work?
Inflation is defined as the decrease in the purchasing power of money over time. Another way to describe this is “the steady increase in the price of goods over time”. Essentially, the world that we live in consistently becomes more expensive due to inflation.
There are plenty of real-world examples of inflation. When McDonald’s first debuted its Big Mac in the 1960s, it cost just 45 cents. Today, that same Big Mac costs $5.11.
Additionally, inflation isn’t just limited to Big Macs. It occurs in pretty much every single product category. The main reason that inflation occurs is that the Federal Reserve prints more money. As the money supply increases, the purchasing power of each dollar decreases.
The Current Inflationary Environment
Thanks to COVID-19 stimulus packages, we are currently experiencing the highest levels of inflation since the 1980s. At first, the Federal Reserve announced that this inflation was transitionary. They blamed the inflation on COVID-19 shutting down supply chains. However, high rates of inflation have persisted for several months now.
In May 2022, the rate of inflation sat at 8.6%. This means that the dollar is losing 8.6% of its value year over year.
To combat this rise in inflation, the Federal Reserve is increasing the interest rate. The interest rate is a tool that the Fed leverages to slow inflation. Raising interest rates makes it more expensive to borrow money and helps cool the economy. With that in mind, let’s examine growth stocks vs. inflation and how these two interact with each other.
Growth Stocks vs. Inflation
When we discuss inflation, we typically focus on how it impacts consumers. For example, higher prices at the grocery store squeeze consumers’ budgets. This makes it harder for people to afford groceries. However, this same scenario happens to companies. During periods of high inflation, it becomes more expensive for companies to manufacture goods.
For example, let’s examine a growth stock like Roku. Roku creates digital media players that plug into the back of a TV. These media players give customers access to streaming platforms. Higher inflation increase Roku’s manufacturing costs. This makes it more expensive for Roku to manufacture its media player. Since Roku is a younger company, it isn’t able to simply increase its prices to offset this rise in costs. Increasing prices could decrease sales dramatically. This puts Roku in a precarious situation.
On top of higher production costs, growth stocks need to deal with higher interest rates. Increased interest rates hurt growth stocks in three ways:
- Cheaper valuations: Investors value growth stocks based on their projected future earnings. When interest rates are higher, investors reduce these projections.
- Less access to capital: Growth stocks require funding from investors to grow. When interest rates are higher, it becomes more expensive to borrow money. This means it will take longer for growth stocks to, well, grow.
- Transition to safer assets: Growth stocks are usually companies with relatively unproven business models. This inherently makes them riskier than assets like value stocks, bonds, or real estate. During periods of high interest rates, institutional investors tend to move their money out of growth stocks and into other assets.
Same Player, Different Team
Growth stocks vs. inflation can be a confusing topic. This is because investor sentiment changes incredibly quickly. In 2021, many growth stocks were flying high. Fast forward just one year, however, and these same stocks are down big. At the same time, not much has changed at these companies. So what happened? To examine this, let’s look at an analogy.
Imagine a star quarterback for an NFL team. This quarterback is dual-threat and prefers to scramble and create plays on his feet. Sports analysts love him and he is very well paid. However, his contract ends and he gets traded to a team that runs a pro-style offense. This style of offense doesn’t complement the quarterback’s skills. For this reason, he likely won’t perform as well over the coming years. Even though the quarterback has the same skill level, analysts start to change their opinion on this quarterback.
In this scenario, nothing inherently changed about the quarterback. Instead, it was his surrounding environment that changed. The same thing happens with growth stocks. During low interest/inflation periods, growth stocks thrive. But, not so much during periods of high inflation.
Hopefully, this has given you a clearer picture of growth stocks vs. inflation. But, we still have to answer a big question: how should you react to all of this?
Should You Still Invest in Growth Stocks?
This depends on your time horizon. Despite the recent selloff in growth stocks, it doesn’t mean that you should avoid them altogether. In fact, high inflationary periods could be a great time to establish a large position in quality companies. However, you will likely have to wait longer for this investment to pay off. Growth stocks may still be successful but it will likely take them longer to reach their growth projections.
I hope that you’ve found this article on growth stocks vs. inflation to be valuable! Please remember that I’m not a financial advisor and am just offering my own research and commentary. As usual, please base all investment decisions on your own due diligence.