Lost perspective: Three things investors have taken too far

This article was first published in the National Post on October 9, 2021. It is being republished with permission.

by Tom Bradley

Thanksgiving is a reflective time. I guess it’s the freshness of the weather, the leaves and the rituals around remembering what we’re thankful for.

From an investment point of view, my reflections this year are on subjects where we seem to have lost perspective. A long boom cycle combined with short memories has created some dangerous misconceptions.

Main Street vs. Wall Street

Central bankers tell us they’re afraid of raising interest rates because it will slow an already fragile economy. That’s what they say, but the effect of monetary policy on consumption has long since diminished. Rates could go meaningfully higher and still be hyper stimulative. A five-year mortgage at double the current rate is still a great deal for homeowners.

No, central bankers are worried about Wall Street, not Main Street. Investors have done well by policy-makers’ largess and are now highly geared to interest rates. Leverage is commonly used to generate returns. For example, cheap debt is a private-equity manager’s most important tool. Stock analysts are increasingly using low-single-digit discount rates to value companies’ future profits. The future would be worth less if they were forced to use higher rates in their calculations.

Today, monetary policy is about capital markets, not your local market.

Public vs. private markets

I keep hearing that private companies are the way to go. That public markets are too short-term oriented, as well as being unpredictable and inexplicably volatile. And that it’s time to go hunting for unicorns with stock-market returns projected to be lower in the coming years.

Well, I’m here to tell you that the love affair with private equity has gone too far. It has obscured the positive attributes of public market investing. Stocks have served investors well for centuries and recent decades have been no less brilliant. They are cheap to access, whether you do it yourself or hire a professional, and are easily tradable. And your portfolio occasionally gets a boost when private-equity firms fall all over themselves to pay a premium for one of your holdings.

Private equity has also performed well, at least for sophisticated investors who have the resources and experience to manage it, but returns vary widely between funds (you need to be in the right fund). Like stocks, returns are projected to be lower. A private-equity manager said to me that when he’s looking at companies to buy, “There’s more people at the table, we have less time to do our work, and we’re paying higher multiples.” In other words, the sector is awash with capital.

I wouldn’t write stocks off just yet. They’re not as bad as they’re made out to be and private equity isn’t as good.

New age vs. old school accounting

The word profit when I started in the business referred to a company’s net income. That is, the amount left over after all expenses are paid and taxes accounted for. In the 1990s, analysts moved up from the bottom line to the EBIT line (earnings before interest and taxes) to compare companies with different capital structures — say, highly levered (at the time) Rogers Communications with more conservatively financed BCE. Since then, we’ve climbed further up the income statement to the now popular EBITDA (depreciation and amortization also excluded) line.

I bring this topic up now because Uber and other new age companies are taking this accounting levitation to new heights. With great hoopla, the ride-sharing giant is forecasting that it will be “profitable” next quarter. The profit being referred to is the company’s version of “adjusted EBITDA” — profit before big expense items such as interest, taxes, maintenance of capital equipment and stock-based compensation, not to mention a list of smaller items. Yes, Uber will be profitable if it doesn’t have to honour its debt obligations, maintain its systems and fully compensate employees.

There are good reasons for looking at alternative measures of profitability, particularly with capital-light companies that are growing rapidly, but, like central banks and private markets, we’ve gone too far in adjusting our perspective.

Bradley's Brief — Q3 2021

Below is Tom Bradley's letter to clients from our Quarterly Report.

The stock market had a pullback at the end of September. The turbulence, which has continued into October, is being blamed on all kinds of things: rising inflation, a real estate meltdown in China, and disappointing corporate profits related to supply chain disruptions and higher commodity prices. The fact is, we never really know why markets rise or fall in the short term.

The current volatility should come as no surprise. After strong markets over the last 18 months, let alone 13 years, we were due for a reset. Rather, the real surprise is how smooth the market’s rise has been since last April. Stocks have powered through COVID concerns and resisted emerging inflationary pressures.

Why has this happened? Well, it comes down to two factors: teamwork and interest rates.

First, stocks have been playing a team game, with different sectors and themes taking turns leading the way. In a golf match, it’s called ‘ham and egging’. Growth stocks (read: technology) have been the most dominant players, but when needed, the cyclicals (economic recovery) have stepped up.

The second factor is far more important. Low interest rates encourage risk taking and inflate asset values. The effect on long-term investments like real estate, long bonds and stocks is profound. In the case of stocks, which are valued on their future profits and dividends, the lower the discount rate, the more valuable the future is.

Unfortunately, declining interest rates have a one-time effect. It’s wonderful owing an asset that is being revalued higher for reasons unrelated to its utility, but once the adjustment has been made, future growth falls back on the productivity of that asset. In other words, when rates stop going down, companies will need to rely on increasing revenues and profitability to move their stock price.

For most of our investing lives, it has been a series of one-time effects, starting in the early 1980’s when interest rates were in the high teens and price-to-earnings (PE) multiples were barely double digit. For 40 years, rates have followed a declining step function to almost zero and PE’s have moved up, albeit haltingly, to the low 20’s.

This year, stock valuations have taken another step up even though interest rates have reversed course. The expansion in multiples has not been fueled by even lower rates but rather a growing acceptance that rates will stay near zero.

Our clients, and other investors holding long-term assets, have benefited tremendously from declining interest rates. Stock market corrections have been short-lived and returns well above inflation, but we should be prepared for tougher sledding ahead. Ham and egging is not a sustainable strategy and interest rates have limited room to go lower.

At Steadyhand, we’re well positioned to slug it out in a tougher investment environment. We’ve never tried to get ahead of macro themes that might lead to multiple expansion (it’s impossible to do consistently) but rather let our fund managers focus on finding reasonably priced companies that are growing their bottom lines. What has been a headwind for us in recent years, namely not having enough exposure to companies that are highly sensitive to interest rates, such as ‘profits-in-the-distant-future’ growth companies and real estate, could become a performance tailwind.

We encourage you to read the rest of our Q3 Report, where we provide more details on our specific strategies and what we've been doing in each of our funds.