QUALIPORT
Interest Rates And Valuation

By Maynard Paton (TMFMayn)
November 3, 2003

This week's Bank of England Monetary Policy Committee meeting is expected to announce the first rise in interest rates since February 2000. Released a fortnight ago, the minutes of the MPC's October meeting led the market to believe a rate hike was imminent, which caused the FTSE 100 to fall 2.5% over two days. But what would an increase mean for the buy and hold investor? When it comes to interest rates, the main focus ought to be on valuation and the effect that rate changes have on returns available from other investments.

To cut a long story short, higher rates are used to curb 'inflationary pressures', by increasing the cost of borrowing. This, in turn, improves the yield attractions on debt-based investments such as bonds and gilts. On the other hand, rates are lowered to help stimulate a faltering economy, by reducing the cost of borrowing. This, in turn, lessens the yield attractions of bonds and gilts.

To put these comparisons into practice, the following table shows the yields from gilts and the FTSE 100 when the stock market reached its all-time high at the end of 1999, and at its bear-market low in March this year:

                     30/12/1999          12/03/2003
Base rate (%)           5.50                3.75

Gilt yields:
  2-year (%)            6.41                3.18
  5-year (%)            6.09                3.63
  10-year (%)           5.48                4.05
  30-year (%)           4.60                4.31

FTSE 100 index          6,930               3,287
FTSE 100 yield          2.04                4.24

At the market high, investors were in buoyant mood, the economy was doing well and rate rises were on the horizon (they subsequently increased to 6% by February 2000). In contrast, during March this year, it's fair to say most investors feared the worst for the economy and expected a cut in interest rates. This duly occurred in July, with a 0.25% cut to 3.5%.

However, in late 1999, ten-year gilts offered an income 2.7 times that of the market's dividend yield. In March 2003, the equivalent 'gilt/dividend ratio' was 0.96. Since 1959, the ratio has averaged 2, which brings the market's over- and under-valuations into perspective.

The next table shows the situation as at last Friday:

                     31/10/2003
Base rate (%)           3.50

Gilt yields:
  2-year (%)            3.99     
  5-year (%)            4.91
  10-year (%)           5.04
  30-year (%)           4.85

FTSE 100 index          4,288
FTSE 100 yield          3.32

Attitudes have changed since the market's low in March. There's now talk of an economic revival in the US, which should benefit many British companies and their employees. The housing market continues to boom, which, unchecked by higher borrowing rates, could threaten the Government's inflation target. All this has prompted the latest round of base-rate rise predictions, and caused gilt yields to increase significantly from levels witnessed eight months ago. Still, the gilt/dividend ratio is presently 1.51 - below its historical average.

Individual shares

To value its holdings, the Qualiport applies the free cash flow yield, which is set by reference to the risk-free returns from gilts. Over the past two years or so, a free cash flow benchmark of 7.5% has been used, which has been at least 2.5% higher than gilts over the same period. If interest rates (and therefore gilt yields) move higher, the portfolio will have to up its free cash flow benchmark to maintain an adequate margin of safety.

The following table lists the historical free cash flow yield of the Qualiport's six holdings:

Company                Share price       Free cash flow yield
                           (p)                   (%)
DFS Furniture             401                    7.98
London Stock Exchange     382.5                  6.26
Halma                     141.5                  6.15
Johnston Press            465                    6.09
Carpetright               823.5                  5.93
Emap                      800.5                  5.75

Going on the current 5.04% return from ten-year gilts, only DFS seems really cheap, while none appear obviously expensive.

Suffice to say, one thing that interest-rate moves (or associated speculation) should not encourage is the buying and selling of shares on 'business quality' grounds. Companies purchased for the long term should be able to withstand interest rate ups and downs, plus all the other unpredictable economic issues, too.

More: Bank of England | Gilts v Dividends | Free Cash Flow Yield.

The author owns shares in Carpetright, DFS Furniture, Halma, Johnston Press and London Stock Exchange.