When rates were higher and we borrowed less, an increase in interest rates of 1% was a fraction of the cost and not so significant. Then when interest rates dropped, more could be borrowed and more was needed because the house prices went up. So, with higher borrowing levels, an increase in the cost by raising interest rates will multiply the cost so small changes will have significant effects.
Many companies did the same as consumers. Money was cheap so borrowed more.
Whilst some are adept at margin analysis for companies, very few are thinking about margin analysis of debt costs. This exercise shows how an increase in rates could have significant impact.
With global debt levels at extremes, we have a loosely held view that it will take fewer rate rises to make a dent in any inflationary pressures that may be building. This suggests that whilst rates are likely to rise, they will likely rise to lower levels than in previous eras.
Omicron
Nothing happens in a vacuum. If Omicron happens to be more virulent, yet less deadly, then many are suggesting that this is bullish for markets.
The issue with this first level thinking is that it obscures the fact that markets react to multiple drivers and interest rates are counter to economic strength. In a weaker economy, interest rates may fall and markets can rise as we saw over the last 23 months. In a stronger economy, markets can initially rise, however eventually fall when higher rates break the back of the strong economy. Thus it becomes significantly more difficult to project market movement as the fear of falling or rising rates can have an even stronger effect on markets.
On top of this is the fact that currencies are also a counterpoint to economic strength and companies’ profits for global businesses which can be hugely affected by currency movements. A weaker economy can lead to enormous profit growth for companies with global earnings, which means they are inversely correlated with the economic growth.
Finally, interest rate differentials can move currencies based on expected short term rate rise potential, which can have a sub effect on an economy changing the actual outcome of the rate rise. If the Aussie dollar went to 85c because it was expected that Australia is to raise rates before the US, it would put a dent on economic growth and thus reduce the need to raise interest rates.
Have we lost you yet? Good, because that is exactly the point. Economics are almost unpredictable to any level of accuracy to time markets. With a third of the world at negative interest rate settings, central bank stimulus at unprecedented levels and unemployment at relatively low levels, what happens next is difficult to predict.
Just because you cannot time markets with economic indicators, does not mean that you cannot reduce and add risk based on valuation and business fundamentals. Valor has successfully reduced risk and added to our portfolios a number of times over the last decade when investments became obviously mispriced.
Valuation still counts
We recently sold half of our ETSY holding. Etsy is an extraordinary company with 83% Return on Equity. Management led by CEO, Josh Silverman, is doing an outstanding job of growing the business and adding more companies to its “house of brands”. We are still very positive on the long-term prospects of Etsy.
We made 70% return in the space of a few months and the stock became quite expensive. We have taken some profits to reallocate the capital into other wonderful opportunities which we think would contribute more significantly to our portfolio returns.
The past cycles of excessive pricing in companies indicate it can take over a decade before the companies return to their extreme price levels. It pays to be prudent at times of froth.
Return Free Risk
We still view the return on most bonds as unacceptable. Much of the bond market trades with negative real yields. To us, owning such assets with limited upside makes little sense.
Every few months there are pockets of value in the bond market. This month, we took the weakness in Sabre Corp’s bonds to add to our less aggressive portfolios.
Sabre Corp is one of only three Global Distribution Systems (GDS) for airline ticketing and other travel solutions partnering with hotels and travel agencies. It has a near duopoly with its closest competitor, Amadeus and their combined market shares stand at around 90%.
There is no doubt that the weakness in airline ticketing has created some fear in the company, however we noted that the bond yield rose from 3.8% to 6.2% in the space of a month at the same time as the company was reducing risk by selling its airline management software business for $392.5 million allowing it to reduce debt. With approximately $1.4bil in cash after this transaction and cash flow likely to turn positive in the coming quarters, we analysed and considered the risk of Sabre Corp bonds to be relatively low compared to its secured 6.2% yield.
It is these kinds of opportunities that we seek for our defensive positions and our ability to be patient in waiting for the reasonable return, yet not extreme levels of risk which should provide more than acceptable returns over time. Sadly, with central bank stimulus over the last few years, the opportunities have been limited.
Australian Unity Mutual Capital Instrument (MCI)
Australian Unity is a diversified mutual company founded in 1840, also Australia’s first mutual wellbeing company. It provides aged care, life and health insurance, health insurance, banking and financial services to its members, customers and the Australian community.
We were able to tap into the opportunity to participate in their MCI capital raising via Mason Stevens’s placement ability.
The business is conservatively managed based on our analysis. We were also comfortable with their diversified operations and moderate debt levels and therefore, we were happy to initiate a tiny position with an estimated 6% yield. Due to the structure of the note being non-cumulative and having more characteristics of an equity than debt, we only took a small position to manage risk.
Festive Season 2021
We were hoping to have an end of year Valor get together as we have had in previous years, yet due to Covid we decided that it was prudent to avoid large gatherings.
We are optimistic that the virus will become less of an issue for society over time and we hope to have a fantastic celebration in the following year to make up for the last 2 years.
We wish you all a safe and lovely holiday season with your loved ones.
Here's to a wonderful 2022!
Cheers,
The team at Valor.
Performance Figures as at 30 November 2021*+
