VALUE INVESTING
Interest In Value

By Stephen Bland (TMFPyad)
December 5, 2003

Interest rates rose a little recently, the first rise for some years. With rates still around the lowest levels for decades, my view is that the most likely longer term trend is up, not that I devote much time to thinking about the future. If you are borrowing money now, to buy property or whatever, consider going for the longest rate fix you can find. But, debt apart, do interest rates matter for value or long-term high yield portfolio shares?

No.

Well, not much anyway. Some types of share may be affected adversely by rising interest rates. Housebuilders for example may find their markets start shrinking if rates rise by substantial amounts, for the obvious reason that since most new property is purchased on debt, fewer people may be able to afford to buy.

Banks are supposed to be adversely affected by rising rates, for reasons not dissimilar to housebuilders, i.e. fewer customers around for dearer loans. However, seeing how bank shares were creamed in a period of falling rates, I am not sure that this correlation necessarily holds true.

Any company with a lot of floating rate debt, such as bank overdrafts, will suffer from rising interest rates. That said value seekers will usually avoid such debt laden shares anyway. The basic reason to avoid debt from a value viewpoint is simply that it increases the risk of the company getting into difficulties, whatever the prevailing interest rate. This increases the risk of holding the share, removing some of the downside minimisation that is a crucial cornerstone of value investing. But it follows, as a side benefit of this approach, that even if a share does not face difficulties through its debt, avoiding it means your value share is protected from an interest rate hit on its profits.

The other side of this is that a company holding a lot of cash, nirvana for value players, will be benefit in a time of rising interest rates because the cash will be on some sort of deposit, earning interest.

Because most shares have net debt, it follows that in general rising interest rates are not a good thing for company profits. However, generalities like this fall into the area of macro matters, which I counsel value players should pay little heed to in most cases. If you wish to devote any attention to interest rates, you should look at this in the context of a particular share you have in mind to purchase or sell. It is unlikely that rates will make much difference to that decision.

One small exception to this may be a peripheral or smell factor associated with rising interest rates in a few cases. For example, the aforementioned housebuilder shares, many of which have been value plays in the recent past. Rising interest rates may possibly signal the start of a downturn, though I expect they will by now have given up their most important value feature anyway - P/TBV under 1. So the deep value will probably have been outed, leaving such shares in higher risk next guy territory. Miners of deep value will not wish to inhabit such a dangerous place.

Generally though, short-term value shares have a way of deciding their own future which arises from the internal characteristics of the company and has little to do with what is going on in the economy generally. Beginners often worry far too much about macro factors in my view. Like minimalism, with value less is more but it can take some time to achieve that state of financial zen.

Turning to the high yield portfolio (HYP) branch of value, the effect of macro factors such as rising interest rates is of no importance whatsoever because such shares are purchased for the very long term. During that very long term, interest rates will fluctuate all over the place anyway.

In my demo versions of HYPs that I portray here on TMF, the minimum holding period is eternity. When you are looking that far ahead you are completely blind. So attempts to divine the future are futile. Never believe anyone who tries to tell you what may happen to any particular share of sector over decades because there is a 99% chance they will be hopelessly wrong. The whole concept runs on faith. Faith backed up by a little practical commonsense such as selecting a sector-diversified portfolio of shares having high yields, increasing dividend history and as a low a debt level as possible.

In conclusion then, my view is that rising interest rates have in most cases no direct bearing on most short-term value plays and none at all, direct or otherwise, on long term HYP strategies.