“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for those forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result”.
– Charlie Munger
This insight from Charlie Munger has had a big influence on how we invest our clients’ capital. In our view, the logic is foundational to a long-term investing approach, and it is a quote I often return to, especially during more challenging markets.
The essential message is that time is the friend of quality assets and if our investments continue to earn good returns, then good returns will ultimately follow, no matter how challenging the short term may prove.
Looking back at our message at the start of the year, we noted that 2022 was likely to be a more challenging year. Following three very strong years, a number of our preferred companies and strategies had become more richly valued and we expected a period of consolidation or pullback.
We also observed that equity markets often struggle to make progress when interest rates are increasing at a faster than average pace and that we would not be surprised to see heightened volatility.
Whilst this view has proven accurate, we did not expect interest rates to increase at the pace they have and clearly this has resulted in a more significant market set-back than we expected.
It is remarkable to reflect that at the start of 2022 the US 2 Year Bond Yield was just over 0.70%. It is now over 4%. This has been a very swift move and it is not surprising that when the ‘risk free’ rate goes from less than 1% to over 4% in nine months that markets have struggled.
Clearly the intent of central banks is to slow the economy in an attempt to address inflation, and ultimately this is welcome. However, in the near term it has resulted in higher discount rates and concerns of recession.
The impact of rising interest rates and bond yields is most obviously seen in the value of fixed interest assets, which fall in value as bond yields rise.
Whilst theoretically ‘real’ assets, with inflation protection, like equities, property and inflation-linked infrastructure assets should fare slightly better, as potential cash flow growth can offset the impact of rising discount rates, these assets have also been re- priced sharply of late.
At the start of the year, we noted that the forward earnings yield for the market, which serves as a reasonable proxy for after inflation returns, was c. 5.5%. This number has now risen to c.7%, or the equivalent of a price to earnings ratio of 14.3.
Looking at other assets, we also observe that a number of our long-held property and infrastructure assets have seen dividend yields move from 3-4% to 5-6%. Naturally when we see this adjustment over such a short period, the impact on capital values is significant.
In short, the dramatic move higher in bond yields, retracing a decade-plus decline in 9 months, has catalysed a broad re-pricing of assets.
Since the financial crisis, interest rates or bond yields have generally trended lower and, despite all the concerns over quantitative easing, inflation remained low throughout that period.
It is possible that the pandemic changed this. Now, I am very cautious to offer a definitive macro-economic view here, as doing so is fraught with difficulty.
However, it is possible that a re-energised fiscal policy ‘muscle’ and structural shifts in labour markets and geopolitics, have altered the landscape somewhat.
Whilst inflation will no doubt come down, it seems quite unlikely that we are going to return to the interest rates and inflation that we saw in the last decade.
This then begs the question as to whether our approach to investing across asset classes should also change.
When looking at US market data, history tells us that when inflation is above 5% it has been problematic for equity markets, with investors seeking higher potential returns to compensate them for the risk. That is to say, valuations have fallen when inflation rises above 5%.
However, when inflation has moderated below this level it has had no discernible impact on the market multiple.
This year, the decline in valuations has been consistent with persistently higher inflation. However, should inflation moderate, in line with longer term market expectations, there will be grounds for optimism. To my mind, this is where the emerging opportunity lies today.
Charlie Munger essentially tells us that our return, as long-term investors, will ultimately be determined by the return that our investments generate.
This is why we focus on higher quality, higher return-on-capital businesses. Unfortunately, these businesses rarely come cheap; we have to pay a premium for quality. However, the longer our time horizon the less important the valuation we pay is, provided our companies can maintain their competitive position and earn good returns on their investments.
This is not to ignore valuation, which clearly matters, and at the start of 2022 some of our companies were trading at above average multiples. Our judgement was that over time earnings growth would result in valuations declining and that we should be very slow to sell really high quality businesses in the hope that we could buy them back cheaper.
Whilst the decline this year has been uncomfortable, we are still happy with this judgement, mindful of our clients’ long term time horizons.
What we see now is very different to the start of 2022. With most of our preferred companies continuing to deliver good earnings growth, against the challenging backdrop, valuations have come back quite dramatically.
Quality still demands a premium today, but much less so, and we feel very comfortable with the price we are paying today for some of the best companies in the world.
Whilst valuations could fall further and the economy will slow, we believe an opportunity is clearly presenting itself for long term, quality-focussed investors.
With respect to our more innovation-focussed equity strategies, these have been particularly impacted by the general re-pricing we have seen. The higher interest rate environment may well have a longer-term impact here, as capital was abundant in recent years and funding will likely be harder to come by for some time.
Ultimately this should be to the benefit of better resourced investment firms, like those we have partnered with, and our view that technological change will present threat and opportunity is unchanged.
However, we also recognise that patience will be required, as the market adjusts to a higher cost of capital.
With respect to property and infrastructure, these assets have also experienced meaningful declines this year, consistent with rising rates and there is no doubt a higher interest rate environment will lead to ongoing re-pricing across such assets. As is normally the case, the public market has adjusted quicker to this reality than the private market.
However, when we speak with our property and infrastructure managers, they continue to observe strong income growth, consistent with the inflation protection qualities of their assets. Of course, this growth won’t be true for all assets, so as ever it is important to be discerning.
Turning to fixed interest assets, a higher inflation and interest rate environment is clearly more challenging.
Investors invest in these assets for greater predictability or certainty of return, and they are generally considered more conservative. Indeed, fixed income investments have often provided a refuge during more difficult times.
However, not in 2022. With the re-pricing of assets, many fixed income strategies have fallen as much as equities. This has been unpleasant for investors who invested in lower yielding, more conservative strategies.
The comfort I offer is that the ultimate return should still equate to the starting valuation. If you invested in a fixed income portfolio yielding 2%, this should still be your longer-term return, even if you have experienced a decline in value and the portfolio is now yielding 3-4%. You also now have the ability to re-invest income at a higher rate, which will be to the benefit of longer-term returns.
Looking forward, with the re-pricing we have seen, the expected return from fixed income is now the highest we have seen for well over a decade. Inflation is obviously a major consideration, but many fixed income strategies are now generating income above where inflation will likely settle.
Considering the above, we do not believe the prevailing environment requires a change in approach.
We are still focussed on investing in what we believe are higher quality assets and we are investing for the long term.
2022 has seen a sharp re-pricing across assets and given the interest rate ‘shock’ we have seen this year; it is inevitable that the economy will slow. Indeed, a recession in Europe now appears inevitable and quite likely in the US.
However, it is important to remember that markets are forward looking, and investor sentiment is very depressed today. It is simply very difficult to know whether markets have made their low or whether we will see a further decline, from which an ultimate recovery should be expected.
What we do know is that valuations have improved considerably and therefore forward returns have also increased. We also firmly believe that our quality focus will reward investors over time, allowing us to withstand more difficult periods and deliver good returns over our clients’ time horizons.
As always, please do not hesitate to contact us to discuss our views further.
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