Inflation at 8.3%
Welcome all new subscribers to Alpha Letter. Every week I write about interesting opportunities in the public market. I focus on stocks off the beaten path. Broken businesses. Assets trading under liquidation value. Macroeconomics and where the economy is heading. I don’t like investing in large, popular companies and find a fascination with assets no one else is looking at.
Today’s piece will be about inflation, rising rates and what kind of companies benefit from higher interest rates.
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Inflation at 8.3%
Stocks collapsed Tuesday after higher than expected inflation data was released. Consensus estimates were expecting 8.1% inflation. Reported numbers came in at 8.3%. Oh boy a 0.2% miss from our overpaid glorified economic experts.
Time to selloff every equity despite the fact anyone who has been purchasing goods and services could have seen inflation in real life. The world is ending and we are all going to die!
In reality the monthly inflation number doesn’t really matter and should not be driving equity valuations this much. At 0.2% miss is nothing. It is meaningless. A nothing burger.
But according to equity markets, everything is going to zero and there is more pain to be had.
In reality, the market is likely selling off equities as the probability of another Fed rate hike went up yesterday. The Fed Funds rate is estimating there is 80% change of a 75bp rate high and a 20% chance the Fed raises rates 100bps. Current rates are at 2.25%-2.50%, which is a meaningful rate increase.
When rates go up the cost of capital goes up. When the cost of capital goes up discount rates increase and future free cash flows decrease. As future free cash flows decrease valuations and asset prices fall. This is what the market is pricing in right now, which in my opinion should have been expected as we all knew inflation was going to be high and the Fed would raise rates in an attempt to cool inflation.
My thought is the Fed will continue to raise rates until there is a meaningful decrease in the monthly reported inflation numbers. Individuals are upset that prices are increasing. The Fed needs to keep the populace content and rising prices is a great pathway for riots and protests as seen in other countries.
As the Fed continues to raise rates to combat inflation, they will trigger a recession as employers layoff employees to deal with the higher cost of capital. Any company not generating free cash flow will experience the drying up of venture capital as entrepreneurs pull back on investments. Tech companies will be forced to layoff employees as outside capital dries up. When high income people are laid off in droves this will effect certain subsects of the economy where these individuals shop. The butterfly effect will continue and impact almost everyone.
The question for an active value investor is; what can we do about it? Everyone will have completely different answers because that is what a market is. In my opinion, these are our options:
Completely ignore the macroeconomic market: This is what I typically do in most circumstances involving most macro events. 99% of the time macroeconomic datapoints are meaningless and should be ignored. But one percent of the time macro events are all that matter. I think we are in the 1% case now.
Dollar cost average: This is always a safe bet for nonprofessional investors. No matter what is going on in the market just invest the same amount of money per month. Overtime you will likely outperform most professional investors and end up with a large nest egg.
Go into a safe haven and take a year off: Invest all of your money into a safe haven and take a year off (or any arbitrary time) to explore the world. Taking time off from the market works and helps analysts decompress their emotions from the market. Now might be the perfect time to take an extended vacation so you don’t make any stupid moves.
Buy assets that benefit from rising rates: There are a handful of asset classes that should benefit as rates increase. Buy these and hold on.
Since this is a stock picking newsletter, the rest of today’s piece will go over a few types of securities that should benefit as rates increase. Buying the right assets that increase in value as rates go up is more of an art than a science. But sometimes only being directionally right in the market is all you need.
Companies that have significant pension liabilities should benefit as rates go up. Pension liabitlies are held on the balance sheet that are a guarantee payment to certain individuals over a set amount of time.
For an example, a coal miner works in a coal mine for 30 years and is guaranteed a pension for the rest of his life. The company that employed the coal miner then has a liability on their balance sheet, offset by a pension asset that pays the pension for this former employee.
Pension assets are liabilities that are influenced by interest rates. As interest rates go down, the liability will increase. When interest rates move up, the liability decreases. Companies that have had large pension deficits will see the liability on their balance sheet decrease and the pension asset increase. This might not seem as intuitive for beginner investors, but wiping out a large pension liability could add millions in future cash flows for investors, increasing equity valuations.
Fixed Rate Debt
Invest in companies with long duration low interest rate fixed debt. The longer duration the better. The more assets backed by the debt the better. When interest rates are 8% and your debt is 3%, you are getting a real rate of negative 5%.
One of the best ways to get long duration fixed rate debt exposure is by owning a home with a 30-year mortgage. I locked in rates at 3.9% with a 30-year term. With inflation at 8.3%, my real interest rate is negative 4.4%. As rents have increased through the city (estimated up 30% y/y) my payment has stayed the same and will stay the same for 30-years. In addition, the replacement cost of rebuilding my place has increased as materials and labor have also increased.
Get fixed rate debt backed by long duration assets.
As rates increase the dollar will get stronger which will benefit anyone who sells in dollars. This includes domestic manufacturers. That being said, a lot of domestic manufacturers are getting pinched from higher labor and energy prices right now. Pick your own poison.
When interest rates increase banks can charge customers who want to take out a mortgage a higher rate. Typically deposit rates should go up on customers but it is unlikely banks will be increasing their deposit rates as fast as they are increasing their loan rates. I would avoid the large banks here as their balance sheets and income statements are more convoluted with assets and liabilities that are hard to understand. Look for small community banks in growing areas. They should do well in a rising rate environment.
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