Lesson 13 – Markets and interest rate cycles
Why bother about interest rates?
Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what is actually happening to the companies in which you’ve invested.
- Peter Lynch
Who am I to argue with Peter Lynch, the legendary fund manager?
Let me start off by saying that this lesson is not about forecasting interest rates.
It focuses rather on knowing what interest rates can do to the companies you own in your portfolio.
Image source: Ken Ratcliff, Flickr
Profitability impact on companies
Consider a company which has an existing loan from the bank at 10%. Usually, banks charge a floating rate of interest. If interest rates in the economy increase, then the interest rate on the loan will move upwards.
Operating margins will not be affected. But profit after tax (hence earning per share) will reduce because of increased interest payments to the bank.
If price to earnings ratio stays the same, then the share price should come down.
Share price = Earnings per share * P/E ratio
Growth impact on companies
Companies which need debt to expand their business rethink expansions when interest rates in the economy are high. They question the viability of projects as prospective interest payments move upwards.
What looked profitable with an assumption of an interest rate of 11% may not look attractive at an interest rate of 15%.
Thus, expansions are put on hold. Growth is hit.
Revenues don’t grow as fast as they used to in low-interest rate environments. They even can shrink.
Think of what happens to real estate, infrastructure and capital goods companies. They announce huge expansions when the times are good. When interest rates rise up and it is tougher to raise loans from the bank, they falter in their growth plans.
Present value of future cash flows and discount rate
You will remember the lesson in which I had discussed discounted cash flow analysis (DCF). We project cash flows into the future and then discount them to a net present value (NPV) as of today. We then compare NPV to market capitalization and see the difference between value and price respectively.
Present value of future cash flows is calculated as follows,
PV = FCFF1/(1+k) + FCFF2/(1+k)2 + FCFF3/(1+k)3 + FCFF4/(1+k)4 + FCFF5/(1+k)5
k is the discount rate.
Weighted average cost of capital (WACC) can be used in place of k.
WACC = Kd * Rd * (1-tax rate) + Ke * Re
Kd = Proportion of debt
Ke = Proportion of equity
Rd or cost of debt can be taken as the interest rate on loans
Re is cost of equity.
If Rd increases, theoretically WACC should increase.
If WACC increases, the denominator in each term increases in the present value formula and hence present value decreases.
If we are in a high interest rate environment today, it does not mean that the high interest rates will continue forever. But at least for the initial years in the PV formula they will affect the PV.
As investors see reduced value (lesser PV) and higher share prices, share prices can adjust downwards.
Be especially wary of cyclical businesses. Auto manufacturers, capital goods manufacturers, power generation companies, and engineering companies fall in this category.
Their revenue growth and profitability is quite dependent on the interest rate cycle. They do exceedingly well when interest rates are low. Cyclical businesses have high revenue growth with increasing PAT margins. When interest rates rise, many such companies have reduced revenue growth (or even shrinking revenues) and reduced profitability.
It is not uncommon to see such companies reporting losses when interest rates rise. Some go bankrupt.
This does not mean that one should not invest in cyclical companies. There are cyclical companies which are protected by moats. These companies will be the leaders in their sector and will usually last the cycle. Weaker companies will perish and not see the next up-cycle.
That is why it is a risky affair in cyclical companies.
You need to pick the strong ones. But just picking the right company does not help. You also need to pick at the right time.
Usually when earnings are growing fabulously and P/E ratios keep rising, one might be tempted to join the ride. But you just might be entering the stock as it hurtles towards a cliff.
When you begin, choose cyclical companies with extra care as compared to non-cyclical companies. I cannot warn you enough. These are the ones in which there is a higher probability of a bad investment outcome.
Historical P/E analysis can protect you. Awareness of the interest rate cycle is very helpful.
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