From my impression, most value investors are bottom-up investors and we here at ValueEdge are no different. In the course of our analysis, we pay no heed to interest rates nor inflation rates and most value investing books at most provide a perfunctory mention. However, a recent conversation with a fellow value investor sparked my curiosity in this topic – conceptually, how does the interest rate and inflation rate environment affect the practice of value investing?
Let’s start with the basics.
Interest rates serve as a basis of risk-free returns. Theoretically, interest rates should play a part in investment decisions because it determines opportunity cost. In most markets, an investment which returns 15% annually would be considered decent, to say the least. Such a perception changes, if say, one could get a 10% interest rate on their fixed deposits. A 15% return on an equity investment would no longer be attractive as it is not commensurate with the level of risk.
Inflation refers to the percentage change in prices of goods and services. Consider a company whose revenue grows at 3% CAGR, while it is far from a growth company, such performance falls right into a value investor’s arena because of its stability. But what if inflation rate for the same period was 4%? It means that the company has actually lost 1% in volume sales which is quite a swing from the original perception of stable 3% growth.
Implications for Investors
Usually, I will have in mind the structure of the full article before I begin but this time, I’m making it up as I go. To me, the main question would be how do/should the relationships identified above fit into a value investor’s framework?
With interest rates, the logical thing would be to demand a higher margin of safety which implies higher returns. This is where things get complicated, as it depends on the type of valuation metric used. For example, interest rate will be reflected in your weighted average cost of capital which is utilized in DCF or EPV calculations. This implies that a value investor does not have to conscientiously adjust his methodology. When it comes to relative valuation, a 6x P/E company in an 1% interest rate environment would definitely be preferred to one in a 50% (just for illustration purposes) interest rate environment. In a 50% interest rate environment, it would have to return 50% just for it to meet the risk-free rate. How a value investor should adjust to interest rate changes depends on the intricacies of his relative valuation strategy. For example, if one adopts a strategy of buying the cheapest decile of stocks (based on P/E), then interest rates would be irrelevant since they are usually subjected to the same interest rate environment. However, if one adopts a belief that 10x P/E companies are overvalued and has an exit strategy of 10x P/E, then the entry P/E would differ depending on respective market’s interest rate. In a 50% interest rate environment, the entry P/E would be 10/1.5 = 6.7x and this is a level with no margin of safety.
Finally, with inflation rates, one insight is that a company’s revenue growth can be a result of either price or volume increase. If I may be brazen, most would regard revenue growth as sales volume growth (us included) which is a form of organic growth and is arguable preferable to price increase. Inflation rates is only a general indicator of price changes in the entire economy and might not representative of a company. On that note, I feel that as long as inflation rates remain minimal, investors can avoid the hassle of figuring whether revenue growth is driven by price or volume (given that such information is hard to come by). But if inflation rate becomes excessive (higher than 7% in my mind), then one should take a mental discount to a company’s nominal revenue and profit growth. In the bigger value investing picture with regards to valuation, inflation is inconsequential to a value investor in most circumstances. While inflation rate would affect a company’s fundamentals resulting in higher valuations, the higher valuation would be offset by lower purchasing power of the investor upon exit. The only exception is if one uses a growth metric such as PEG which is a tad uncharacteristic. In such a case, then the same relative valuation concept as in interest rate applies.