Suppose you think interest rates are going to go up, and you are trying to choose between alternative investments. Of course, rising rates will reduce bond prices, and so you prudently decide to invest in stocks rather than bonds.
But, if you expect rising rates, should you choose growth or dividend stocks? From what I hear on business television, the obvious choice is growth stocks. Dividend stocks, so the “experts” say, are similar to bonds because they are primarily bought for current income. And, like a bond, when interest rates rise the dividend-paying stock’s price will decline. This last part I fully understand. Ceteris paribus the price of a dividend-paying stock will decline when interest rates go up. Stock prices reflect the discounted value of expected future cash flows. When interest rates go up the present value of a given cash flow stream will fall.
But what will happen to the price of growth stocks? Growth stocks are generally those high-flyers that are not presently paying any dividends because the companies are reinvesting all their cash in new projects whose payoff will occur in the more distant future, if ever. Based on what I hear and read in the media, conventional wisdom is that when compared to dividend stocks, growth stocks prices will be less sensitive to rising rates. And this is the part I don’t get.
Bond traders are usually pretty good with math. And they understand that the “duration” of a bond determines how sensitive the bond’s price is to changes in interest rates. A short-term bond whose duration is only one year will suffer a 1 percent decline in price for every 1 percent rise in rates. A bond with a longer duration, say 10 years, will go down in price by 10 percent for every 1 percent rise in rates.
Now, shouldn’t the logic be the same with stocks? A dividend stock that is paying a known cash flow each and every quarter has a shorter duration than a growth stock that is paying nothing now, but offers the (faint) hope of large cash flows in the distant future. Using duration as the guide, rising rates should drop the price of the short-duration dividend stock by a lesser amount than the long-duration growth stock; the talking heads have it backwards–in the face of rising rates I’ll bet on the dividend stock that is giving me cash now.