Interest Rate Risk
Good morning. It is getting wild out there in public markets. Interest rates continue to increase. Valuations will keep falling. Cash is becoming more valuable by the day as you can plug your cash in risk-free treasuries earning a respectable yield.
Over the weekend I wrote up company that I have continued to buy. Check it out if you are a subscriber. I think the company is bought out in 2023 for a value much higher than the current price.
Today I am going to talk about Mark Cuban and his experience investing in treasury bonds, a new valuation metric I invented to value cash rich companies and industries that will see a reckoning from higher interest rates.
But before we get into today’s newsletter, first a word from today’s sponsor…
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Mark Cuban and Treasury Bonds
My entire investing career has been in a near zero interest rate environment. Never in my life have I been able to get an attractive risk-free return by simply keeping my money in a savings account or treasuries. I was gifted savings bonds as a kid from various family members, but outside of those savings bonds, I turned to the stock market to generate attractive returns.
I remember listening to a podcast a few years ago where they interviewed Mark Cuban. As a young adult Cuban wanted to desperately accumulate enough money so he didn’t have to work for someone else. Build up your cash pile and and live off your investments — something I am sure many of us think about.
Cuban mentioned in the podcast he read a book titled something along the lines of “how to retire early with bonds”. The book advised readers to accumulate $1 million dollars, dump the money in treasury bonds and collect an 8% yield for the rest of your life. The glory days of the 80s where high interest rates were the norm and anyone with capital to put to work made an easy and predictable return.
Cuban followed this strategy and retired in his 30s. He then took his $2 million he accumulated and turned it into $20 million by purchasing tech stocks. The rest is history. I have doubts Cuban is investing in treasury bonds these days. But if we get back to a 8% risk-free yield, his strategy of buying startups might change.
A new way to value cash rich companies
The rapid rise in interest rates is just now starting to make an impact on the economy. Banks are beginning to fail. Tech companies are laying off unproductive employees. Commercial real estate investors who locked in ultra-low rates will soon need to refinance their properties in a higher rate environment with lower asset valuations. Soon asset allocators won’t touch anything unless it yields them a 6-8% or better annualized return. Good bye non-cash flowing businesses.
For the first time ever, I am considering buying treasuries. I have cash sitting on the sidelines. My hurdle rate for companies to invest in has increased. As rates went from 0% to 4.25% my internal discount rate has also increased by this much. If I invest in a company it has to offer an incredible rate of return along with downside protection. Higher interest rates are making me more of a picky investor.
It’s not only investors who are becoming more picky from higher interest rates but public companies as well. I have spent my entire career on the buyside, never seeing a company mention where their cash is held. On Thursday a company I own spoke in their 8-K how they hold $20 million in a money market fund with a 3.75% interest rate.
The company has an enterprise value of $19 million and should generate $750k from interest on their cash alone. I’ve been thinking about the implications to higher interest rates on publicly traded companies and what it could mean for valuation purposes. Will investors soon invent a new valuation formula such as enterprise value to interest income (EV/Interest Income)? Take the former company as an example:
$19,000,000/$750,000 = 25.3x - $19 million enterprise value with $750k of interest income for a EV/interest income of 25.3x
I don’t think anyone has ever used an EV/interest income formula before as it just hasn’t made sense in the past. But should we start using this now for companies with large hoards of cash on their balance sheet that can be put to work in risk-free treasuries? It doesn’t seem unreasonable to me. In a zero rate environment I was seeing tech companies get 50x EV/Adjusted EBITDA valuations four years out in the future.
Shouldn’t companies who are overcapitalized with management teams that have hoarded cash — not returning it to investors via repurchases or dividends — get a much higher valuation for the first time over cash well capitalized companies for the first time ever? This cash went from earning nothing to making an attractive annualized return, basically overnight. Any company with a large hoard of cash will generate a real return for their investors just from balance sheet allocation in treasuries — interest income should start running through your DCF models if you have not already adjusted it yet!
Downfall of industries
As higher interest become the new normal, industries will begin to fail. Companies that don’t generate cash from day one will get more scrutiny from investors. Their forward valuation multiples will fall as cash will flow to value based companies that actually generate cash. If you are a cash strapped VC with a poor business model, watch out!
I wish I saved down this one VC company I found a year or two ago. The founder was a lady on the Forbes 30 under 30 list. She started a company that manufactured ESG space helmets. Literally ESG space helmets. I thought it was a joke at first. You can start any business in the world and you pick one with a total addressable market of literally 20 people. A lawn mowing business or porter potty rental business will generate more money with less risk than a company selling space helmets to 20 people per year. I’m sure her company has shut down now as VC investors are just now learning what due diligence is for the first time in years.
Another industry that is due for a reckoning is commercial real estate. Commercial real estate investors have enjoyed a decade of low interest rates, which increased valuations and made money cheap. For the first time in a decade, commercial real estate investors will need to refinance their properties at a higher interest rate.
Banks will continue to have issues if these higher rates to increase. Depositors for the first time can make an active decision on where they want to allocate their excess cash. If a bank cannot compete with treasuries they will see their deposit base decrease. As their deposit base decreases the chance of a run on the bank occurring increases. We are living in a dangerous world where capital is about to become scarce.
Where does this leave us?
It is tough to tell what rapidly increasing rates could do to the economy. My best guess is we enter a recessionary period over the next 12-18 months as asset valuations come down, employees are laid off and capital becomes scarce. Companies with excess cash on their balance sheets should perform well as they can use the cash to collect a risk-free return or invest in industries that see their valuations fall. If the Fed continues to tighten banks will fail and investors will panic.
It will be a fun time over the next few months. Save money. Invest in strong companies. And be ready to buy assets at cheap valuations.
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