Crazy times make for crazy markets

Blimey. Well, I don’t know if crazy is the right word for it but if you’d told me back in 2019 that over the next two years I would face a multi-year global pandemic, a stock market rout, a six month recovery following by ever more rich valuations, then a collapse of global supply chains, skyrocketing inflation and Russia launching an invasion of a sovereign nation pulling the markets back down to earth, I would probably have laughed at you. Still, here we are, two months into 2022, and I’m struggling to point at a six-month period since the beginning of 2019 that’s felt ‘normal’ in all that time.

Let’s start with the latest – the Russian invasion of Ukraine. The illegal invasion of Ukraine. The murder of Ukrainian citizens. The string of increasingly deranged propaganda videos from Putin. Leaving the geopolitics to one side, it has to be said that the war is a dreadful thing – and the sooner it ends, the better. If you’d like to do something to help, maybe consider giving a donation to the UNICEF Ukraine appeal, or the British Red Cross, both of whom are acting to provide much needed humanitarian support to citizens that have been affected by the outbreak of war.

I won’t position myself as an expert on Putin, the Soviet Union, or the causes of the conflict. The only thing I will say on the topic is that I am dreadfully sorry for anyone in the country and that I sincerely hope that the conflict can be brought to a swift end with as little bloodshed as possible. The scenes coming out of Ukraine are, as with all wars, horrendous. The poor people of Ukraine did nothing to deserve this aggression and any right-minded person must surely condemn Putin for choosing to both initiate and continue to perpetrate this appalling violence.

Moving on to something a little closer to my area of knowledge, however, is the impact that these events have been having on global stock markets. Since the outbreak of war on the 26th, the Russian Ruble has lost 40% of it’s value against most major currencies, the Russian stock exchange has plummeted nearly 50% and volatility has shot through the roof. During a conversation with a fellow investor this week, I reflected on my recent poor performance – 6% down for the year so far and around 8% down from my all-time high.

The question is, what am I doing about it? Well, as most readers will know, I try not to act in haste or anger when it comes to my portfolio and instead have taken a deep breath and largely run a repeat of what I did when the 2020 crash happened. In short, not much. Most of the positions I hold are in high-quality, profitable companies and the few positions I hold which are of a more adventurous nature are well-researched businesses which I understand well, meaning that sudden increases in volatility and price movement don’t tend to scare me out of them.

There is one big question mark for me which I am still trying to figure out, however, and that is the question of rising interest rates. Readers will know that I have only been tracking my performance since 2015 and as such struggle to identify a time of persistently rising interest rates. 2017-19 saw two increases from 0.25% to 0.75%, hardly astronomical rates and for almost as long as I can remember the base rate has been well under 1% in the UK. I remember a time, it seems like a lifetime ago, when interest rates were more like 5% – but it’s so long ago that I can’t honestly say I was investing at the time.

According to the data from the Bank of England, interest rates were rising, almost uninterrupted, from 2003 up until mid-2007, after which the financial crash happened, and they were all but eliminated.

As such, I have no lived experience of managing a portfolio through a rising cycle or when interest rates are at ‘normal’ levels. I understand the theory behind it though. Interest rates act as financial ‘gravity’. The higher they get, the lower asset prices become. This is because borrowing money to buy assets (mortgages and margin loans) becomes more expensive and alternatives (saving money rather than investing) become relatively more attractive. This forces bond yields up as bond prices fall and depresses stock multiples as equity prices fall.

In theory, this means that the most heavily impacted equities should be those which are priced most highly, which are loss-making, and which are primarily based on future returns. This is because of the idea that share prices reflect future cash flows. When interest rates start to rise, the discount rate of those future cash flows is increased.

So why do we increase interest rates? Well, in a sense, the government has to in an attempt to reign in inflation. With interest rates at rock bottom for over ten years, speculative activity in the economy has skyrocketed. Add in a supply chain crunch pushing up commodity prices and a boom in demand after the global COVID lockdowns and prices are soaring. Most people want low interest rates because it means they can borrow money cheaply and use it to buy everything from expensive cars to bigger houses. When interest rates are increased, the cost of borrowing that money increases, making it less likely that those people want to borrow money to consume. This reduces demand in the economy and helps to keep prices stable, hopefully weakening inflation before we all end up paying £100 for a loaf of bread.

If you’re still with me, then you see the problem I now face in managing my portfolio. Most of my companies have been bought at prices when interest rates were at the lowest ever levels, with price multiples that reflected this. Of course, as a largely value investor, I am pretty conservative with my purchase prices – the average P/E of my portfolio is only 14.

Despite this, if multiples come down across the board as interest rates rise, then it is likely to affect the entire market. Companies that were on a P/E of 14 might only rate a P/E of 10 if interest rates triple. The effect will be most strongly felt with expensive companies – I’d hate to be holding companies on P/Es of 30 or 40 in this market (and I suspect the rout of companies like Games Workshop – £120 down to £74 a share – and Bioventix – £44 a share down to £30 a share, reflects this).

Likewise, loss-making companies become infinitely less attractive in a rising-rate environment. If it only costs you 0.25% a year to invest in Palantir rather than save in a bank account, you might be willing to take a gamble, but that choice becomes considerably less attractive when your mortgage costs have doubled and bank accounts are paying 4% a year.

And what do I think is likely to win in a rising interest rate environment? Well, financial equities tend to do fairly well; banks can increase the spread between the money they charge borrows and what they pay lenders. Insurance companies tend to do well as they are compelled to hold government bonds for safety, which begin to yield more in rising interest rate environments. If interest rates are rising due to a strong economy then consumer goods companies tend to do well as employment increases and demand for discretionary goods increase (although this is partially off-set by the decrease in demand for credit).

Finally, you have those businesses which are benefitting from macro-economic tailwinds. Just because interest rates are rising doesn’t mean that successful businesses are suddenly going to stop being successful (unless that success is based on debt, in which case buyer beware!). Certain technology businesses, companies with strong profit margins, businesses representing innovation (and no, that doesn’t just mean Cathie Wood despite a recent interview…).

Taking this into account, I am still a buyer of equities – just a slightly more cautious one than I was six months ago. As interest rates rise, multiples are likely to take some sharp steps down. In theory, if a business is growing, then it’s share price ought to tread water, or perhaps grow very marginally, but if a the share price could only grow by increasing it’s price multiple, then I would expect the price to reverse – and sharply.

One move I am glad of is my increased cash position – I suffered in 2020 as prices fell and I was unable to act, being fully invested at the time, but this time around, I am able to take advantage of price dislocations as I see them. The trick, of course, is to be a discerning purchaser of equities – a careful curator of the best opportunities – and to avoid overhyped ‘meme’ stocks and speculative gambles.

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