Rotation to Value & Opportunities in a Rising Rate World

Herro: There are several factors playing out today that make us believe the growth paradigm is ending. It has been in place since the Global Financial Crisis (GFC). Central banks were using very soft monetary policy to get us out of the crisis. Then came the pandemic and central banks had to kind of double down to keep the economy intact. But now, that soft monetary policy has to be reversed. Because, as we know, the velocity of money is picking up, inflation is picking up – a result of this excessive fiscal and monetary stimulus. So, that “lower for longer” environment is shifting. Negative interest rates we have seen in Europe and low rates across the globe are now rising.

With rates so low, there have been some factors that have meant that companies with nice cash flow streams were almost at a handicap versus companies that don’t generate cash. If you believed rates would stay low forever, then you were happy to own growth-oriented companies that don’t generate free cashflow in the short or medium term because the discount rate is so low. Now, in an environment with rising inflation, rising interest rates, it becomes much less attractive to invest in businesses with low or little cash flow streams.

Nygren: We think as interest rates reset to a level that’s more consistent with the Fed’s inflation target at two percent, almost half of our portfolio should benefit from that. Our financials should earn more money because they can earn more on their deposits. Energy companies directly benefit from higher prices, and we think many other holdings should do well in terms of strong competitive dynamics that give them price power. If we start seeing five percent inflation, a lot of our companies may not be able to pass through the full five percent, but they’ll pass through three or four percent price increases and that will allow them to better keep up with inflation.

Herro: I think there's both. Transitory, due to advocating of demand policies over supply policies. And as the pandemic unwound, a complete incorrect economic policy was instituted; the supply side should have been focused on rather than the demand side. So, this is causing transitory inflation. And then more permanent inflation exists because there is too much monetary stimulus in an environment where the velocity of money will stop falling.

Central banks around the world have been bailed out by a low velocity of money over the last decade, which was caused by the recapitalization of the global financial system post the Financial Crisis. All these banks had to build reserves, from 3 or 4 or 5 percent of capital to 12-13-14%. And now, there is too much money in the system, especially when you have velocity picking up. So that's the structural aspect that has to be dealt with – with monetary policy. So, I believe the solution to inflation is you have to tighten monetary policy and you're going to have to advocate supply-side policies.

By the way, now that these financial institutions are at or above their required capital requirement, we think the next decade is going to be good for their owners. Every dollar they generate they can now use to grow their business or give it to the owners. Whereas in the past 10 years, every dollar they generated, some of it had to go into reserves.

Nygren: When we think about value and financials, the banks are an industry that, over the past 30 years, have averaged a price-to-earnings multiple of about between two-thirds and three-quarters of the S&P 500. So if you think of the S&P today as selling at about 22 times earnings, two-thirds of that is about 15, 16 times earnings. So three-quarters would be just a touch higher than that. And we believe the financials are better businesses than they’ve averaged over the past 30 years. They have a lot more equity against the assets that they hold. Economies of scale – the importance of that has grown largely because of things like spending on information technology, fraud protection, and mobilization. All of those expenses grow with size but they don’t linearly scale with size. So we think it is creating a bigger and bigger advantage for the large banks.

Nygren: I think people are very anxious to get back to vacation travel. We’re also seeing business travel picking up. We started business travel May of last year, and I got to visit with 30 to 40 of our companies, one-on-one, in person, and it’s so much better than trying to talk to them over a conference call. I think we’re in the eighth or ninth inning of being worried about Covid as a disease, and I think we’re at the peak of restrictions. We are starting to see people preferring to travel and get out in areas where the restrictions are less. That hasn’t translated to stock prices. We don’t think we’re anywhere near the ninth inning for an online travel booking company. We think some companies’ earnings are going to be a lot higher as people resume international travel, especially when European travel starts to pick up as the United States travel has.

Some commercial real estate firms could be a kind of back-to-the-office play. They make a lot of their money on maintenance for office buildings, and maintenance has been cut way back. We expect profitability for them to increase as more people get back to the office. So I think the evidence of the actual reopening occurring keeps getting stronger and stronger, and the value case for the names that will benefit from reopening, for the most part, continues to exist.

Herro: It's what is to be expected from an economy run by a command economic structure. They want to show who's the boss, similar to the regulations enacted on certain sectors of their economy by the way. Therefore, they exercise this authority. Is it good? I really don't think so because you're not going to stop Covid, first of all, as we all know. And number two, the impact on the global economy – it will heighten the supply chain issues that we're already experiencing. Now they've managed to do workarounds. But I think, most importantly, it's not a good policy because it's just an authoritarian move that is not at all corroborated by proper science.

Herro: In essence, it's the same game plan as what we've been doing for more than 30 years. We focus on what the underlying intrinsic value of business is. And if "Mr. Market" moves in a violent and aggressive direction different than fundamental value, we react by adding or trimming our investments. And in this case, the value of business isn't just the next week or month or quarter, it's the present value of all future cash flow streams.

So, when companies' prices drop 20, 30, 40 percent in a couple of weeks, and you are convinced the underlying intrinsic value has not, then opportunity awaits – whether it's adding to existing positions, which we believe have been unfairly hit, such as areas like the European financials sector, or even adding a few other businesses. Volatility provides opportunity if you have the nerves and conviction for it.

Nygren: At Harris Associates, we are long-term value investors. Our portfolios are based on our fundamental analysis, and we look for three things in any company we consider investing in. We want the stock to be priced at a discount to our estimate of business value; we want business value to be growing as fast as other companies – as fast as the S&P 500^® Index; and we want management teams that are aligned with their outside shareholders.

Clearly, stock selection is the strength we bring to the table. We are not market timers in any way and, in order to maximize the impact our stock selection has on the portfolios, we run focused portfolios, generally between 20 and 70 names. Compare that to a typical mutual fund today that owns somewhere between 100 and 150 names. Each stock that we decide to own has a much bigger impact on our performance than it does for our peers.

We invest for a very long-term time horizon. If you have something that is undervalued and the value’s growing at least as fast as other companies – and management is aligned with outside shareholders – it gives us the luxury to think really long-term.

Nygren: Our analysts forecast out to a five to seven-year time horizon. I think of that as bringing a private equity perspective to investing in public equities. We’re looking at what a business looks like today, how different it might look five to seven years from now, and how differently investors might value that same company if it goes along the path that we expect it to over the next five years.

Many private equity firms typically buy poorly managed companies where they have to change out the management teams. We differ from them by trying to identify well-managed companies where we want to partner with the existing management teams. This helps us avoid getting into a situation where there could be somewhat of a race against time of the team destroying value while we try to change out management.