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Intelligent Investing: Looking beyond Interest Rates

Low interest rates have been a defining feature of the investing landscape in recent years. The rate on the benchmark US 10-year Treasury Note has been in a 40-year downtrend (Exhibit 1), leading to sub-3.0% yields for the better part of the past decade.

Exhibit 1: An Era of Falling Interest Rates

10-Year Treasury Yield

Source: Artisan Partners/Bloomberg. As of 31 Aug 2022.

Fast forward to today: the benchmark rate is approaching ~3.5% or almost 300bps above its August 2020-lows due to the highest inflation since the early days of the Reagan administration. While these levels are still low compared with the 10-Year’s ~6.0% average yield since 1962, this has been a huge move in only two years.

Amid a potential interest rate regime shift, we think there is a timely but also timeless message for investors. While the bond market has likely implications for asset valuations broadly, as well as changing sector and style preferences, as investors we do not lower (raise) our cost of capital assumptions when interest rates fall (rise).

To determine the value of a business, investors calculate a discount rate to discount future cash flows, commonly using the weighted average cost of capital (WACC). The prevailing thought has been to reduce cost of capital assumptions in line with lower interest rates. However, do lower interest rates truly reduce a company’s risk? We are not convinced. In fact, the opposite may be true. Lower rates equal cheaper money, which may create more competition. Increased competition magnifies risk and therefore should cause investors to raise their required return.

Take the shipping and logistics industry as an example. Do lower interest rates reduce the competition faced by FedEx, UPS and Amazon? Furthermore, what influence do lower rates have on daily operations, on-time rates, hiring decisions, pricing strategies, network efficiency, digital capabilities and asset utilization?  The answer is “none”. Competition does not lessen due to lower rates. So as equity investors, why would we lower our required rate of return on the risk we are bearing?

What we believe ultimately matters to a company’s long-term success is its economic moat—its sustainable competitive advantages. Prime examples are dominant market positions, proprietary assets, including brands and patents, a low-cost market position, customer relationships and distribution networks. When we assess competitive positioning, we are usually using a similar lens that Michael Porter identified in his Five Forces shown in Exhibit 2.  Nowhere do rates implicitly play a part in assessing competitive forces.

Exhibit 2: Porter’s Five Forces

Source: Michael E. Porter, "How Competitive Forces Shape Strategy", Harvard Business Review, May 1979 (Vol. 57, No. 2), pp. 137–145.

Additionally, while lower rates help companies borrow more cheaply, they tend to help overleveraged businesses most. In fact, low rates had been a tailwind for leveraged businesses, acquisitive companies and aggressive business models during the post-GFC period. These types of businesses are not our focus. As one of our margin of safety criteria, we require a sound financial condition in each of our investments. Companies with healthy balance sheets can reinvest in their business, make acquisitions at opportune times, return capital to shareholders and/or pay down debt.

As investors of equities, we do not think of ourselves as owners of pieces of paper; we see ourselves as owners of businesses. As Benjamin Graham stated, “investment is most intelligent when it is most businesslike”. As a business owner, we do not lower our hurdle rates when interest rates fall. We require compensation for the risk we bear, and business risk is not tied to interest rates, it is tied to economic moats and business models. Thinking like a business owner, means you care most about competitive positioning and the economics of the business—its cash-generating and return on capital capabilities. These are the attributes we believe are the necessary ingredients for long-term prosperity.

 

 

DISCLOSURES:

Margin of Safety, a concept developed by Benjamin Graham, is the difference between the market price and the estimated intrinsic value of a business. A large margin of safety may help guard against permanent capital loss and improve the probability of capital appreciation. Margin of safety does not prevent market loss—all investments contain risk and may lose value.