Towards the beginning of the month the US inflation numbers came out lower than expected. Whereas the tone from the Fed around US interest rates before this was how many more 75 basis point hikes to implement, the general tone afterwards seemed to change to lower hikes of 50 basis points and perhaps a limited number of further hikes.
These interest rate hikes are coming out of a period of record low rates, and as we discussed in a previous article titled "Stock Picking or Interest Rate Bets?", some of the technology company, and technology company funds’ successes we have seen in the last few years may have more to do with low interest rates than special insight. As we discussed previously, this was due to something called equity duration. Equity duration is the cash-flow weighted average time at which cash flows from a company are received. Given that most stocks mentioned above are focussed on future technologies, not many of them are expected to generate meaningful cash flows in the near-term. When cash flows of companies are further into the future, the valuation of these companies becomes more sensitive to changes in interest rates. That is because the higher the interest rate is, the lower the current value of those discounted cash flows will be.
Now with rate increases levelling off, would this situation arise again, where rates drop off and it becomes attractive to hold shares with far out cash flows? Firstly, I think we need to keep in mind that rate increases aren’t over. Maybe the expected size and number of increases has come down, but the interest rate will still go higher. Additionally, comments from the Fed indicate that interest rates will stay elevated for longer in order to avoid any inflation mistakes made in previous decades. So, it seems that ‘free money’ at very low rates is not coming back anytime soon. And when they do come back? There has been so much value destruction in the wake of the most recent market corrections. Extremely high valuations on companies not expecting to produce any earnings for a long period of time have come down in many cases over 90%. I once read somewhere that it takes about 20 years for the same or similar bubble to remerge. This is because you need a new generation who forgot the negative effects last time to buy into the hype the next time around. I don’t know if this is true, but it’s interesting this all happened around 20 years after the dot com bubble.
The bottom line now seems to be that if you are waiting for valuations on companies that don’t make money any time soon to pick up to the stratospheric levels we saw in the last few years, it may be a long wait. The good news is the market is full of different kinds of companies at different points in their life cycle and with different earnings and cash flow capabilities. And many of them are trading below their intrinsic value. At 36ONE, we still see plenty of opportunities.