note*: I define value investing here by the act of buying companies that are undervalued substantially as compared to their assets. By definition, all investing should be value investing. But I hope this clarifies it more clearly.
There have been remarks that value is dead or that growth has beaten value and if you continue to be a value investor, you’re just a fool.
I believe most of this is just a style discussion, but I also believe value investors will see the light of day soon as they exit the dark tunnel of growth. (although it is also inaccurate to say that growth and value can’t coincide….)
The picture is a pretty damning. Value has been trounced like a dusty carpet in the past few years by growth.
There are many various reasons for this and I will go over the biggest one here before I finish with why I believe Value style investors will eventually see rewards at the end of the rainbow.
You need money to make more money….right?
The biggest impediments to starting a business is – you guessed it – capital.
I don’t care what new age hippies that tout themselves as gurus have to say. You don’t get to make money without capital.
If no money was needed to make more money, everyone would be mega rich and the price of resources would explode upwards.
After awhile, everything ends up being normalised down again because (a) resources have scarcity and (b) demand has a supply ceiling it cannot breach without artificially causing massive short term price spikes.
How have the Federal Reserve influenced and changed all of this? By dragging interest rates into a back alley and shooting it in the head.
Simple. The biggest impediment to borrowing money is the bloody cost of it. In other words, interest rates.
Let’s run through an example to understand why interest rates are so damned important.
Let’s pretend 2 different chicken rice sellers are competing with one another. Both of them have the same skill and churn out equally good tasting chicken rice.
The first seller of chicken rice – Uncle A – is older. More established. The second seller – Kaki B – was his disciple before he left, starting his own chicken rice store.
Only one thing separates them – the interest rate on the money they borrowed from the bank in order to start up the chicken rice stall.
Uncle A started a long time ago, say, around 2004-2008, when interest rates were higher.
Kaki B started later, after the financial crisis, when it seemed safer to start a business after he knew he could borrow cheaply.
Who wins this fight assuming both have similar prices for their chicken rice, and assuming neither has a competitive advantage asides from interest rates on the money they borrowed?
At 5% interest, Uncle A owes $5,000 in interest repayments on a $100,000 loan.
At 1.75% (current Fed Funds rate), Kaki B owes $1750 on a $100,000 loan.
Over time, Kaki B gets to take the repeated difference in profits of $3,250 and open a 2nd stall, a 3rd, a 4th.
And each stall then snowballs, adding more and more advantages until Uncle A, who originally only fought with one stall, now has to close up shop because Kaki B has bought the whole damn street.
I will grant that this is an oversimplification, but you get the point. Low interest rates are good for growth stocks because cheap credit allows a company to borrow extensively without fear of mounting debts and then skyrocket their reach.
High interest rates act as a natural barrier because competitors must be able to earn higher margins than you in order to compete at a similar level by borrowing cost.
In other words, the bar for performance is lower now than it ever was for competition and it’s because the US Federal Reserve – or is it Trump? – (which indirectly affects global interest rates) has decided this is the best way forward.
Thus, those who invested in growth companies like Facebook, Visa, Microsoft, Amazon have seen their prices skyrocket. I’m not discounting the fact that this are good companies, but lowered interest rates cannot have hurt them.
Look at oil in America, billions of dollars borrowed to make America go from a net importer of oil to a net exporter of oil – all fuelled by cheap capital.
So why is all of this about to reverse? Ask Thanos
Resources are finite.
Sure. Yes. I hear you. Production goes through the roof and makes certain resources cheap as hell – like oil per barrel – but that sets off its own time bomb.
At a broader level, when capital becomes easy to acquire, resource prices jump because demand increases.
Look at the earlier example. Ten more stalls is a lot more chicken demand. Now take that and multiply it by a billion across all sectors, all businesses, and all countries.
What happens to the prices of commodities when everyone’s pockets are deeper?
Inflation happens. Drinks go from $1 to $3.
What happens when inflation happens?
Simple. Interest rates rise.
Because lenders lending you $1 now with $1 of buying power want to receive more than $1 in the future with more than $1 of buying power back – and that future won’t exist if inflation rises and you end up paying them only $0.70 worth of buying power 30 years from now.
Who the hell wants to lose money lending money? No one.
So what happens when interest rates rise?
Because interest rates rise, and lenders demand more money, those companies with loans tied to prevailing interest rates (and trust me, most of them are all tied to a floating interest rate, its how they grew in the first place) suddenly see profits take a nose dive as everyone has to pay more money back to lenders.
Thus the scales of the economy are balanced, as all things should be.
Buffett himself noted this aspect. He also highlighted a weird investments using bonds in an environment where interest rates were just higher.
To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates.
Interest rates act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull.
That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.
Consequently, every time the risk-free rate moves by one basis point–by 0.01%–the value of every investment in the country changes.
People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect–like the invisible pull of gravity–is constantly there.
In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there–in that tripling of the gravitational pull of interest rates–lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.
Then, in the early 1980s, the situation reversed itself. You will remember Paul Volcker coming in as chairman of the Fed and remember also how unpopular he was. But the heroic things he did–his taking a two-by-four to the economy and breaking the back of inflation–caused the interest rate trend to reverse, with some rather spectacular results. Let’s say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16, 1981, and reinvested the coupons. That is, every time you got an interest payment, you used it to buy more of that same bond. At the end of 1998, with long-term governments by then selling at 5%, you would have had $8,181,219 and would have earned an annual return of more than 13%.
That 13% annual return is better than stocks have done in a great many 17-year periods in history–in most 17-year periods, in fact. It was a helluva result, and from none other than a stodgy bond.Warren Buffett
When interest rates rise, having fully paid up assets matter
We want to buy assets cheap, and own the business for free. Assets for cheap confers strategic value. A value that sky rockets when interest rates climb.
Why is this the case?
When interest rates are high, businesses buying assets suffer setbacks. And while technological companies don’t necessarily operate using assets, lots of companies still require hard assets (land, buildings, machinery, even cash) to operate.
Businesses that already paid up for their assets will enjoy a significant operating advantage versus their peers who now must pay the price of higher interest in order to compete.
This means over time, undervalued companies with real assets paid up should see more share price appreciation because they see better earnings and better profits, all else being equal.
So why will all this change soon?
Several factors are pointing to it. Chief of all, inflation.
We haven’t seen it hit core consumer baskets yet (though some are already bitching about electricity bills), but we probably will pretty soon.
The prices of oil – and in relation, energy – has been cheap for a very long time because low interest rates allowed a shale boom to kickstart the US economy out of the gravitational pull of the 2008-09 great financial recession.
Consequently, shale and natural gas supply flooded the market and naturally led to lower natural gas and oil prices.
Even oil, with prices affected by tension and OPEC cutting/increasing supply and geopolitical volatility has suffered.
Some of this is due to the corvid19 virus now destroying oil demand, but it’s not like oil was having a good time prior to this in 2015 and onwards.
What’s the kick that’s coming?
Remember that interest rates allowed a shale boom?
Well, that debt is coming home to roost. All time low nat gas and oil prices mean that a lot of oil companies are going out of business because the cost of production is above the cost of gas.
They’re putting $1 into the ground and digging out less than $1.
That can’t go on forever.
And in 2020, this year, they have $71 billion worth of debt coming at their face.
Corvid19 has only helped to accelerate the bankruptcy of the oil players who weren’t making money.
Even if it hadn’t, shale producers can’t keep producing forever at a loss, and the rising energy prices will quickly envelop the system, a direct effect on you, me, and everyone else.
- It’ll cost more to deliver products
- It’ll cost more to generate electricity in your homes.
- It’ll cost more to take the MRT to go to work, to top up the fuel tank.
- And you’ll start doing what everyone else starts doing – tightening up in other areas of expenses to make up the short fall.
I think rising energy prices from the shale fall out sends us towards a bust. And I think it’ll help value investors broadly because for once, valuations of companies across the board will get to be reset to more attractive levels.
I don’t like making market predictions. I have no edge there.
I’m not an economist. But I am a student of our history. It doesn’t repeat but it sure as hell rhymes.
And right now, it’s singing an awfully familiar tune – the energy tune.
The last five major US economic recessions were caused because oil prices were just untenable.
It’s hard to look at the facts and walk away thinking all’s well ends well.
- I’ll continue to look for companies with little to no debt in a business where their services are needed and with a sector trend in favour at their back.
- I’ll continue to try and buy assets (real assets worth economic value!) cheap own the business for free.
- I’ll continue to check that management has skin in the game.
- I’ll continue to only buy cheap companies where insiders are aggressively buying shares or companies are performing share buybacks at optimal levels without using debt.
If valuations stay suppressed for too long, good companies with management that has skin in the game will just buyback shares anyway or delist (because they can buyback cheap and retain all profits rather than share it with the public) and that means share prices go up – allowing you and me to profit.
It’s a win no matter how you look at it.
So don’t lose heart.
Value investing never dies.
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