The interest rate trap

SG Hiscock & Company
Hamish Tadgell
Hamish Tadgell
SG Hiscock Portfolio Manager and Head of Research
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“When securities prices are high, as they are today, the perception of risk is muted, but the risks to investors are quite elevated.”

Seth Klarman, Baupost Group


“Everything in valuation gets back to interest rate.”

Warren Buffett


Interest rates and asset prices

As a high-conviction bottom-up investor, one of the biggest challenges SGH has faced over the past 12 months has been balancing the growth prospects of individual companies against low rates and valuation risks.

The idea that “lower interest rates justify higher valuations” is one of the most basic principles of finance. It’s no surprise that renewed expectations (and delivery) of further rate cuts has reinforced the demand for yield and growth stocks.  However, in many cases, it seems without due regard for the accompanying earnings and valuation risks.

Our worry is there is a growing mentality of yield-scarcity among investors; where they are not quantifying the effect of rates and simply deciding that “there is no alternative" to blindly speculating in risky assets regardless of their valuations.

As rates go down and investors chase yield it causes the price to rise and present value of assets to rise. This gives the illusion that investments are providing good returns. However, the reality is the returns are just being pulled forward by the “present value effect” and future returns will be lower. 

As this illustration shows, like gravity, the fundamental truth of investing is the higher the price you pay today, the lower your return will be in the future. 




The risk is future returns, in the form of yield, won’t be sufficient to meet future liabilities, and investors will have to sell assets to meet future obligations.

Today this seems most obvious in the bond market with US$15 trillion of global bonds yielding zero or below zero. These investments are worthless for producing income (unless funded by further liabilities that have even greater negative returns).

It’s also observable in the multiples being paid for high growth stocks and REITs, infrastructure stocks and a number of industrial stocks. Many of these investments are considered as safe places to hide until they’re not safe, and it’s recognised they offer poor future returns, or because rates eventually rise and their prices go down.

For the moment, valuations and equity markets are being supported by more dovish central banks and fading trade tension concerns. Following the Fed’s dramatic policy shift and ‘Powell Pivot’ it would appear investors are now assuming the Fed remains sensitive to negative financial markets and rising credit spreads more than the risks of rising financial asset prices and extreme monetary policy.

Dr Phillip Lowe, the Governor of the Reserve Bank, recently commented along similar lines when he said:

“There are investors who think the outlook is sufficiently weak that they expect central banks right around the world to cut interest rates but they are not worried about corporate profits or credit risk .. I don’t’ really understand that .. so to me, it seems it’s a strange world”.

There is still some room for rates to fall lower and central banks to stimulate a bit more. This could see a further shrinking of risk premiums and rise in equity markets. But what this is forgetting is that lower rates won’t do much, if anything, for corporate earnings.

From a portfolio perspective, the challenge is balancing the growth prospects of individual companies against low rates and valuation risks.

If growth remains positive but more moderate, we believe growth companies will remain appealing. In particular, we see companies with strong top-line sales growth (CSL, James Hardie, Carsales.com) and companies that are reinvesting for growth (Collins Foods, Macquarie Group, Seek, Woodside Petroleum) as more likely to prosper.

More than ever, we think it is prudent to maintain valuation discipline and stick to our process given it remains very unclear whether the market tops on deflation or inflation being anticipated.

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OUR PROCESS

We believe in buying great companies at good prices. We are firm believers in co-investment, demonstrated by our significant investment in our own funds. Our confidence in our investment approach means we always seed new funds with our own money. We have made the decision to cap our Funds Under Management at modest levels, to ensure that the funds retain greater flexibility to generate strong investment returns across varying market conditions. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.

OUR ENVIRONMENTAL, SOCIAL AND GOVERNANCE POLICY

SG Hiscock & Company has a formal board-endorsed environmental, social and governance (ESG) policy. This incorporates the key principles of the Australian Council of Superannuation Investors, as well as the framework provided under the United Nations’ Principles for Responsible Investment. SG Hiscock & Company is a responsible investor and we take an active approach to integrating ESG considerations into our investment decision-making process. We believe that the effective governance and management of business risks has a direct impact on a company’s intrinsic value over the long term and helps to reduce investment risk. In order to identify the best opportunities for our clients, we undertake a broad fundamental research program which incorporates an extensive company visitation schedule. With an experienced team of investment professionals, our approach to analysing companies is designed to ensure no stone remains unturned.

We engage with a hand-picked team of external research providers to complement our insights in the macroeconomic landscape (both locally and abroad) and general investment trends. We also have an exclusive joint advisory arrangement with one of the world’s largest commercial real estate investors; LaSalle Investment Management Securities, LLC is a subsidiary of global property giant, Jones Lang LaSalle. This provides our property team access to LaSalle’s research capabilities.