Uncertainty has a certain attraction for value investors

All investors need to think hard about what a sustained – and, for many, unfamiliar – environment of higher interest rates could mean for their portfolios

Before May 2022, the last time UK interest rates were above 1% was February 2009, which means anyone in their mid-30s or younger working in finance has never had to operate in an environment with any meaningful level of interest rates. Indeed, inflation has not been above 10% since 1991 and so there are very few people still working in finance who have experience of impactful levels of inflation.

Almost inevitably, then, investors will be making mistakes today without realising it. Perhaps it will be in the tech space, where less liquidity will make funding rounds more difficult. Perhaps it will be related to the idea of meme stocks, of NFTs or of bitcoin and other cryptocurrencies. Or perhaps it will be something we do not even realise is going on in some dark corner of the financial world – it certainly wouldn’t be the first time.

Whatever it may be, as investors, we need to think hard about how this changing environment could negatively impact our portfolios. One broad area is to make sure the companies we buy into are in a position to service their debt at ‘old normal’ interest rates. After all, when thinking about corporate health, for many investors ‘net debt to EBITDA’ has for a long time been pretty much the only balance sheet ratio that needed to be considered.

In other words, the importance of interest cover has been largely forgotten. Yet, as recent jitters in the US banking sector showed, liquidity can be the most pernicious of problems. Assessing corporate health in terms of interest cover – understanding which companies have unhedged debt and may struggle to service that interest in an environment of rates thought impossible just a year ago – is likely to be crucial to performance.

What next for banks?

A more specific areas to consider is the banks. After yet another round of negative headlines, it would be easy to give up on our longstanding position in the sector – but, first, it is well worth noting a couple of points. First, despite those headlines, most – though not all – UK and European banks have performed well so far this year. A sharp spike upwards (which is easy to forget) was followed by a sharp downdraft (which is not).

Second, after significant upgrades to their earnings forecasts, banks as a whole now trade at half the market multiple – close to the 20-year low set during Covid. They remain a significant position for us, here on The Value Perspective, as we continue to believe in the long-term attractiveness of this unloved sector from both a valuation and an income perspective.

That said, banks are the only global sector to have seen consistent positive earnings revision over the last two years and the majority of bank shares we own have rebounded very strongly off their lows – necessarily leading us to reduce our weighting to them over time and recycle the proceeds into other undervalued areas of the market. Doing this has been facilitated by the broadening out of the overall value opportunity set.

Please remember, past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

On the eve of the pandemic in March 2020, our global portfolio had a combined weight of 40% in banks, energy and materials. Today the combined exposure to these is less than 20%, and they account for the three largest reductions in sector weights over the last three years. Conversely, the sectors where we have increased exposure the most include telecoms and pharmaceuticals – two traditionally defensive sectors.

Healthy opportunity set

The key takeaway here is the global stock universe is big enough and wide enough that the value opportunity set is extremely healthy today. Here on The Value Perspective, we pride ourselves on being very picky investors and yet we have been able to increase the number of holdings in our global portfolio from the low 30s to the mid 50s. This also means our sectoral exposure is as diversified as it has ever been.

One final point on this new interest rate ‘paradigm’ is that uncertainty tends to be good for a value investment style. When the market was operating in an artificially buoyed and protected environment of quantitative easing, with lower-for-longer interest rates and low volatility, few new investment opportunities were being created and performance could suffer as a consequence.

On the other hand, when uncertainty increases and emotion reigns – as fear (or greed) takes over – share prices move by more than is justified by fundamentals and thus opportunities are created. Periods such as the dotcom crash in 2000, the global financial crisis of 2008/09 and the Covid crisis all created the conditions for strong subsequent returns for value investors.

Unfortunately, there is no playbook for what stocks or sectors we will buy or indeed sell. All we can do, here on The Value Perspective, is to strive to be guided by valuation and build diversified portfolios that are not beholden to one sector, one theme or one macroeconomic outcome. Over time, that simple aim and simple process should compound to deliver strong returns for investors.