Sunday, November 27, 2022

Stock investors needn’t lose sleep over rates

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This investment column is all about disclosure and guaranteeing readers that I back up what I write with my own money. Hundreds of you emailed since my introductory ramble last week to ask why I chose the funds that I have.

Fear not. Over the coming weeks and months, we will explore every major asset class under the sun. But as for implementing an idea in practice, the sad truth is that many of us are restricted in our choices.

For example, my Aviva pension offers only a dozen funds. If that were not pathetic enough, the biggest and second most successful equity market in history — the US — is not even on the list. (The reader who emails me the best performing one since 1900 gets a gold star). It’s almost as if the plan trustees meet each quarter with the sole purpose of denying their members an early retirement. Hands up those who think we should include an S&P 500 fund. Didn’t think so. How about a short duration credit fund? Unanimous!

This is why I was forced to buy BlackRock’s world (ex-UK) equity index fund on September 29 this year. I had been sitting in cash, or rather a sterling liquidity fund, since January, and with US stocks down almost a quarter, it felt like a good time to jump back in. Everyone was bearish and moaning their heads off — usually a buy signal. While not a pure play, US companies make up 70 per cent of the fund. It was the nearest I could get.

I also wanted some US mega-cap technology names, which had fallen even further than the wider market, but not too much exposure. Apple, Microsoft, Amazon and Alphabet are all in the top 10 holdings, but it’s still a diversified global fund. I chose the ex-UK version as I already owned a UK fund, which we covered last week and will return to in more detail soon. So why was I happy to add US equities to my portfolio? Most strategists remain bearish. To answer that question one must also have a view on tech stocks, given their chunky weighting.

Whether tech is in secular decline or is just having a wobble is currently a topic of huge debate. My colleague (and finest ever hire) Robert Armstrong has summarised the arguments nicely in his Unhedged newsletters. Much depends, it seems to me, on a simple question. Do good old-fashioned valuation techniques work for big tech? If yes, the sector remains expensive. On the other hand, if you reckon these companies walk on water and transcend the usual earnings, balance sheet and cashflow-based analyses, lower prices are a chance to top up.

While I’m wary of the believers (every bubble has them telling me why traditional metrics don’t apply), I also know that the even more widely held view that higher rates have caused the tech sell-off is wrong. It is very important for readers to understand this because we hear all the time why higher rates are bad for stocks. Indeed, the main reason cited for this latest mini-rebound is the hope that the Federal Reserve won’t be so aggressive on rate rises from here.

This is not a simple topic, however, and involves some understanding of company modelling. One way I explain to new analysts why rates don’t affect valuations was inspired by an interview I read with a famous hotelier when I lived in New York during the financial crisis. (I’m sure it was Ian Schrager, but capitalism was supposedly ending at the time, so I was pretty distracted).

He claimed never to worry about the economy. In good years more guests come through the door. In downturns, however, staff, laundry, food and furniture are less expensive — and potential new sites are a bargain. It balances out in the end, he said.

Likewise, the reason so many people misunderstand the relationship between interest rates and share prices is because they forget that rates mirror future states of the world. They rise when an economy is thought to be heating up and fall again when expectations cool. Growth and rates cannot be separated — just as it is more expensive for Schrager to decorate his rooms when they are full.

And yet people constantly unlink the two. Finance writers and analysts like to show how clever they are by reminding us that the value of a company is derived from its future cashflows. And indeed it is. They then go on to argue that if this stream of money is “discounted” at a higher rate, its starting point must be lower today — a company’s net present value declines, using the jargon. Conversely, if rates fall, share prices must rise.

But it is only half of the story. You cannot just change the discount rate in your company model and not adjust revenues over the coming years. It would be like Schrager boasting about how much money he will make because costs have fallen, while not assuming bookings will follow suit. When I was a young equity analyst, we would sit around a table with our models and one of the first things we would check is whether our discount rate was consistent with our estimates for top line growth.

Higher interest rates must be counterbalanced by higher top lines and vice versa. Valuations remain unchanged. Inflation pushes revenues up too. That it all balances out in the end is not just theoretical. Look at a long-run chart of equity prices and interest rates in the US, for example, and you will see there is no relationship whatsoever.

Sure, over the past two decades borrowing costs have fallen while shares soared. But in the 1950s and 1960s, rates and stocks moved upwards together. Go back and read the financial press in those decades and everyone thought that was the norm.

No, I wanted exposure to US stocks because they should be a core part of any portfolio. They are cheaper than they were, and I am happy to ignore the higher rate doom-mongers. So should you.

The author is an investment columnist and former banker. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__

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