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Buffett's way on rising interest rates

Updated: Sep 12, 2018





 

In the last thirty to forty years we all benefited from decreasing rates and general higher indebtedness capacity. Even though our families may have not participated directly to the trend, they have probably participated in some other way. An example of indirect benefit of increasing debt and spending power would be the following: a company is able to take greater debt at lower cost in time (lower rates); the same company is able to employee more people; those people go shopping spending their salaries at small and medium businesses of the company’s town; the whole town around the company benefits from higher access to debt and liquidity. Maybe one of our parents was an employee at that company or maybe he or she used to own a grocery store in the same city; we are all likely to have benefited from that situation.


With our posts at m-odi we try to deal with trends we think can impact the majority of us and can shape the long-term success of many. We do not think we can give readers clear receipts or solutions, we think our posts are possible approaches to personal and specific thought-process to be then developed by individuals. In this post we want to deal with something that we think will impact in many ways our lives regardless of the attention we pay to it. However, we think we need to spend time on that in order to be able to deal with it in a planned and, hopefully, effective way.


As we anticipated few months ago in our post “The future will be different for our investments”, we think an important trend likely to develop during the next decades is the combination of rising inflation and interest rates. Even though there could be crises of different nature in the middle – which we are unable to predict – we think the trend above is still very likely to materialize and maybe have some sort of cause-effect relationship with possible abrupt events.


One way we used in the previous post to describe possible dynamics in periods of rising rates is to reference the decade of the 70s and some US indicators; that was the last period of big rates’ increase then followed by the decreasing trend we benefited from. We show once again below the rates’ increase of the 70s (blue line) and the general good earning power of US businesses regardless of the period (red line -- inflation has an important role in that period too).


In this post, we want to try to make one step further and exploit the invaluable experience of extremely direct and sharp investor Warren Buffett. We want to try to highlight possible effective strategies for those kinds of periods. We do not want to do that through his direct words because we do not want to risk misinterpreting his message; we will do it by giving you directly our takes on his annual shareholder letters from that period. You can obviously find his material online.


The chart below constitutes an important reference for our following discussion in order to show that despite good earning power of businesses and economy in general (growing trend of the red line in the previous picture), rising rates determine lower valuations (represented below by the P/E ratio during the 70s; how much investors were willing to pay for specific cash-flow earnings from investments):


&P500 Price over Earnings ratio, shaded areas US recessions (source: macrodtrends.net)

Our takes:


As the reader may realize going forward in this reading, good practices are useful not only in specific situations but, are safe and good practices in general. Moreover, they are often two sides of the same coin.


The main takeaway is that periods of inflation and rising rates do not welcome weak finances. Sound finances (e.g. excess liquidity in order to handle debt and its interest despite decreasing purchasing power caused by inflation) can give us the option to choose which unfortunate situations we want to carry through the end of the inflationary period. Assets lose value during rising rates and we may prefer not to be forced to sell them at discount and realize losses. Moreover, what may seem sound today may not be sound tomorrow: inflationary periods require extra liquidity because of lower purchasing power in time; liquidation may be the only choice in case of distressed finances.


Another take is that playing the long-term game seems even more important now. Again, that is something we should always do but, in positive periods – the past decades – short-term speculation was more easily forgiven considering the general trend of appreciation. Usually, in those positive periods we like to think we are the determinants of our success but, we are often just subject to confirmation biases: the reader can try to compute a portfolio of about 10 stocks chosen randomly from the S&P500 in 2008 and keep them untouched till 2018; even though some companies will fail or they will be taken private, the rest of the stocks will yield exceptional returns not really related to the investor’s ability (on average across 10 years the random portfolio would earn almost +200%, similarly to the S&P500 but, the insight is that about 85% of them will make money ... 10 stocks is basically already a fairly good diversification). The opposite is likely to be true during inflationary periods, with an additional tweak though: good businesses and investments are likely to go through unfavorable mispricing in periods of abrupt rates’ increase and the only way to realize the full underlying value will be to carry them through the end of the period. That obviously means that choosing investments on the base of short-term appreciation despite weak earning power could cause big disappointment. That applies to speculation in a broad sense; one example: in the last decade some venture capital and private equity practices have been relying on general rising exit-valuations in order to partially overcome assumed expected returns (therefore required ones) not representing real risk-adjusted ones; this is likely to end.


The last take we want to mention is that good opportunities will still be possible but, they will be realized years after initiation. Even though periods of rising inflation and interest rates are in general harder than others, good saving and investing opportunities will be possible thanks to lower valuations (lower P/E) and even mispricing (P/E even lower than risk-adjusted level) of good and bad opportunities. However, good opportunities do not mean that some investors will prosper in times during which others will suffer; even catching good investments in adverse times is likely to yield good returns only through the end of the trend, when lower inflation and rates will allow for higher purchasing power and valuation of the same earnings.


In general, it is important to note that the period we are discussing and likely to materialize in the following decades does not forgive mistakes that easily, even though some will be made. Therefore, we hope we will all pay attention to this possible trend and design actions specific to our situations.



 

This post does not constitute in any ways investment advice

 

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