Is It The Right Time To Go For Growth Stock?

Investing in growth stocks involves identifying companies with exceptional growth potential and allocating capital in the hope of capitalising on their future success. While growth stocks have historically outperformed the broader market during bull runs, they can also be more volatile and subject to greater price fluctuations. Bhavya Rathod highlights whether it is the right time to go for growth stocks 

The Indian economy has demonstrated remarkable resilience and growth potential, even in the face of global uncertainties. The past decade has witnessed India’s emergence as one of the fastest-growing economies in the world. This economic momentum has had a profound impact on the Indian stock market, attracting both domestic and international investors seeking high returns. Amidst this backdrop, growth stocks have emerged as a compelling investment option, promising substantial rewards to those willing to take calculated risks. [EasyDNNnews:PaidContentStart]

Investing in growth stocks involves identifying companies with exceptional growth potential and allocating capital in the hope of capitalising on their future success. These stocks typically belong to companies operating in sectors characterised by rapid innovation, disruptive technologies or evolving consumer preferences. While growth stocks have historically outperformed the broader market during bull runs, they can also be more volatile and subject to greater price fluctuations. 

Therefore, evaluating whether 2023 is the right time to invest in growth stocks in the Indian markets requires a comprehensive analysis of various factors that influence their performance.

Current Economic Conditions

The monsoon season in India initially had a sluggish start, but it has gradually gained momentum and now has covered a considerable portion of the country. The intensity of the monsoon can significantly impact inflation rates, which are anticipated to reach 5 per cent or higher in the second half of the financial year. Considering the volatility of food inflation, a below-normal monsoon or uneven distribution could push inflation closer to 6 per cent. A pertinent illustration of this is the soaring prices of tomatoes, which has garnered significant attention. 

The members of the Monetary Policy Committee (MPC) have expressed confidence in India’s sustained growth momentum, despite the likelihood of a weakening global growth trend driven by domestic consumption and investment cycles. With a positive outlook on domestic growth, they are placing greater emphasis on maintaining the 4 per cent inflation target in the future. The decision to withdraw accommodation is justified by the fact that financial conditions have improved, liquidity is abundant, and there are potential inflation risks arising from El Nino, which could impact food prices. 

In response to the increasing rate hikes by global central banks, the MPC is expected to maintain its current stance and not make any changes in the next two policy meetings, given the combination of a delayed monsoon and easing financial conditions. However, a clearer picture is likely to emerge in October regarding the monsoon situation, the trajectory of the Federal Reserve’s policies and next year’s domestic inflation. Depending on these factors aligning with the RBI’s projections and the absence of any negative global surprises, there is a possibility of a change of stance in December. 

This could be followed by a potential rate cut in either February or April. This course of action will be contingent on inflation projections remaining in line with the RBI’s targets. The Indian economy is showing signs of greater stability than initially anticipated, demonstrated by a robust Q4 GDP growth rate of 6.1 per cent. Furthermore, the projected growth figure for FY23 stands at an impressive 7.2 per cent. In response to these positive economic indicators, investment and brokerage firms are already speculating that the RBI might consider revising interest rates, but in a direction favouring a downward adjustment.

Falling Interest Rates and Growth Stocks
 

With the RBI maintaining its stance of pausing rate hikes, it appears that there won’t be any further increases in interest rates. Instead, there is a possibility of witnessing a gradual shift towards rate cuts. While declining interest rates can be advantageous for all sectors, growth stocks stand to benefit the most. To comprehend this relationship, let’s explore how lower interest rates impact the economy and subsequently lead to advantages for growth stocks. 

1) Reduced Borrowing Costs — One of the primary ways falling interest rates aid growth stocks is by reducing the cost of borrowing for companies. When interest rates are lower, businesses can access capital more affordably, making it easier for them to fund expansion plans, invest in new projects, and improve their overall financial position. This creates a feasible environment for growth-oriented companies that typically require higher capital investments to fuel their expansion. Imagine you are starting a small business and need a loan to fund your venture. When interest rates are high, the cost of borrowing is like hiking up a steep hill with a heavy backpack on your shoulders. But when interest rates fall, it’s like finding a smoother, less steep pathway to climb, making it easier for you to reach your destination (business growth) with less effort (lower borrowing costs). 

2) Attractive Valuations — As interest rates decline, fixed-income investments such as bonds and bank deposits become less appealing to investors. This prompts them to seek higher returns in alternative assets, including equities, particularly in growth stocks that have the potential to generate superior earnings’ growth. As demand for growth stocks increases, their valuations tend to rise, making them more attractive to investors. Think of the investment landscape as a real estate market. When interest rates are high, people prefer to invest in rental properties or government bonds (fixed-income) as they offer reliable, steady returns. But when interest rates fall, those traditional options become less profitable. As a result, investors shift their focus to fast-growing neighbourhoods (growth stocks) with the potential for higher returns on their investment. 

3) Stimulated Consumption and Demand — Lower interest rates also have a positive impact on consumer spending. When borrowing becomes cheaper, individuals are more inclined to take loans for big-ticket purchases like homes, cars and other consumer goods. This increased consumption stimulates demand across various sectors, benefiting companies with strong revenue growth and potential to capitalise on consumer spending patterns. Consider a water reservoir that supplies water to a city. When the reservoir’s gates are opened wider (lower interest rates), more water (money) flows into the city. This leads to increased construction of houses (consumer spending), boosting the demand for various goods and services (growth stocks) needed to support the growing population. 

4) Currency Depreciation and Export Boost— Falling interest rates can lead to a depreciation of the Indian rupee against other currencies. A weaker rupee benefits export-oriented companies as their products become more competitive in the international markets. Many growth stocks are part of sectors that rely heavily on exports such as information technology and pharmaceuticals. Consequently, these companies experience improved profitability and higher revenue growth due to increased demand for their products and services abroad. Picture the Indian rupee as a racing car. When interest rates fall, it’s like the car’s engine revving up, making the rupee go faster and cross the finish line (foreign markets) ahead of other currencies. As the rupee accelerates, exporters (growth stocks) on the car (currency depreciation) gain a competitive edge in the global race for market share.

Interest Rate and Growth Stock Performance

To understand how growth stocks perform during rising and falling interest rate we did an analysis of relation between MSCI India Growth index (representing growth stocks) and average change in ten-year Government of India bond yields (representing interest rate). In the last 13 years of annual data we have seen that there is negative correlation between change bond yields and performance of growth stocks. 

An analysis of the table reveals that the correlation coefficient between the change in bond yields and the MSCI India Growth index is approximately -0.082. Though it is not a very strong relation, there is a negative relation. The reason for such relation is because growth stocks, which are characterised by their potential for rapid earnings’ growth, may face increased scrutiny when interest rates rise. Investors may become more risk-averse and seek safer investments such as fixed-income securities that offer higher yields due to rising interest rates. On the contrary, when interest rates decline, fixed-income securities often offer lower yields. This can lead investors to seek higher returns in riskier assets, including growth stocks, potentially increasing their demand and driving up their prices. In year 2023 till now we have seen a decline in bond yields, which augurs well for growth stocks.

Outlook

Amid a slow-growing global context, India has managed to thrive by providing an opportunity for sustainable growth at the macro level. The markets have witnessed a remarkable rally of over 9 per cent on a year-to-date (YTD) basis, primarily supported by a stable macroeconomic outlook and favourable crude oil prices. These factors have contributed to India’s economic prosperity and have been instrumental in bolstering investor confidence and market performance. The encouraging Q4FY23 and Q1FY24 earnings’ reports have further reinforced the notion of sustained demand traction in the market. Notably, the Small-Cap and Mid-Cap indices have outperformed the larger benchmarks in the current quarter, signifying a trend of narrowing valuation differential. 

This development reflects increased investor interest in smaller companies and indicates a potential shift towards a more balanced and diverse investment landscape. The strong performance of these indices suggests that investors are finding value and growth opportunities beyond the larger, more established companies, and it also highlights the overall resilience and attractiveness of the Indian market. Listed companies are witnessing a renewed interest from foreign institutional investors (FIIs) and recent signals from the central bank indicate a potential shift in monetary policy direction away from rate hikes. This has sparked speculation that India might follow a similar trajectory as China did from 2007 to 2011. 

During that period, China and India shared similar GDP and GDP per capita figures, and now India finds itself in a comparable position to replicate China’s growth pattern uring those four years. Over a span of four years, China experienced a significant surge in gross capital formation (the consumption component of GDP) and exports – nearly doubling their figures. India could potentially replicate a similar trajectory at present, supported by the initiation of a major capital expenditure upward cycle bolstered by our production-linked incentives (PLIs). As a result, growth stocks may continue to maintain justified valuations in the market, driven by the anticipated growth and expansion in various sectors fuelled by these positive economic developments. 

However, it can be stated with confidence that the recent substantial increase in the prices of essential food items, many of which have doubled across India, has exerted pressure on the RBI. The heightened volatility in food prices may lead to an upward trajectory in inflation for the second half of the financial year 2023-2024, thereby potentially advancing expectations of a rate cut by the central bank. After raising rates by 250 bps, the Monetary Policy Committee (MPC) has adopted a pause, maintaining the status quo since its April 2023 meeting. The MPC is currently observing the impact of the higher lending rates. 

However, given that food holds a substantial 40 per cent weightage in the overall inflation basket, the RBI remains vigilant, particularly in light of the potential El Nino effect on food prices. The government has given the RBI the mandate to maintain retail inflation at 4 per cent with a permissible deviation of 2 per cent on either side. In May, the retail inflation rate, as measured by the consumer price index (CPI), decelerated to 4.25 per cent. That said, if such a scenario unfolds, investors must remain vigilant and closely monitor the RBI’s actions before making significant investment decisions in growth stocks. Despite the optimistic sentiment surrounding growth stocks, it is essential for investors to exercise caution as these stocks inherently carry higher risks as compared to value stocks. 

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