Offshore investing - Allan Gray
Offshore investing

Teenagers, curfews & interest rates

A few weeks ago, I was woken at 1:30 am by a teenage son and a friend of his. They were downstairs in our kitchen.

They were trying to cook spaghetti bolognese… while singing at the top of their voices.

It’s safe to say that I was NOT tempted to join in.

I was reminded of this episode recently while listening to the CEO of the Markel Corporation, Thomas Gayner, talk about interest rates. He likened interest rates to a form of negative curfew: “When you’ve bought a house and interest rates are at 13%, you don’t go out much!”

My son was clearly a product of the ZIRP (zero interest rate policy) era!

Now, teenagers clearly need to experiment with going out and learning all the perils that accompany that, including what an irate father looks like when woken up in the middle of the night.

Thankfully, teenagers’ attempts at cooking don’t take very long to clear up.

However, global interest rates have been held at or near zero for most of the last decade. Companies, and investors, have effectively been encouraged to stay out partying until dawn… for years on end. The clear-up operation from this could take a lot longer.

The return of inflation in 2022 has sparked a turn in the tide for interest rates. No one knows how and when this will end, but it’s clear the ZIRP era is over.

Warren Buffett has talked about the receding tide revealing who has been swimming naked. I suspect that if a normalisation of interest rates only reveals some cases of skinny-dipping, we will be able to count ourselves as relatively lucky.

As interest rates have risen, we have seen a collapse in the valuations of a range of profitless tech companies. More recently we have seen a crisis in the US regional banking sector. Some of these players didn’t just leave their clothes on the beach, they loaded up on cocktails before taking to the water.

What comes next is anyone’s guess.

So, how can investors plan for the next decade when the tectonic plates appear to be shifting so dramatically?

I think there are three things that should be front and centre for investors in 2023:

  1. Inflation is, once again, a real hurdle. While cash provides some optionality and some cash is essential to have as an emergency buffer, it locks in a guaranteed loss of purchasing power. So, be wary of holding excessive amounts for any long period of time.

  2. What has worked well over the last decade is unlikely to work well over the next decade. Falling interest rates have been an enormous tailwind to a wide range of investment types over the last 30 or 40 years, particularly long duration assets such as growth stocks and real estate. If that cycle has turned, winners in the next cycle should look very different.

  3. True diversification is more valuable than ever. Having lots of holdings in your portfolio does not necessarily make it diversified, if those investments all perform in a very similar manner. This was a painful lesson for some in 2022. If the performance of your individual investments in 2022 did not vary by much, chances are that you need to increase your effective diversification. An area many investors appear to be neglecting recently is value stocks.

True regime shifts happen so infrequently that we don’t get much practice in spotting them. The good news is that active opportunities within stock markets remain extraordinarily attractive. Cycles are not just about the broad rise and fall in asset prices, but the widening and closing of valuation gaps within asset classes.

In 2021, the gap in valuation between cheaply and richly priced shares was wider than we have ever seen it, on a variety of measures. On a simple price-to-earnings ratio, it still is. That suggests the opportunity to beat the market by hunting for attractively valued stocks is unusually good. As the valuation gap closes, inexpensive shares could generate very healthy returns — even if the wider market is struggling.

That is an exciting environment for investors willing to be different. It is not too late to act on this one.

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