At Heron Bay Capital Management, we believe quality businesses with superior economics will generate superior investment results over the long-term. Our approach remains constant regardless of day-to-day market noise. In the current environment, supply chain disruptions and inflated prices have driven a news narrative which anticipates the Federal Reserve raising interest rates. During the past 13 years, interest rates dropped to record lows and stayed there. That created a boon for financial assets and equities alike. Companies could borrow and expand. On the other hand, low interest rates meant that investors had almost no alternatives for generating low risk return and many investors have taken disproportionate risk as a result. The mass injection of money into the economy - 4 rounds of quantitative easing and fiscal stimulus checks - combined with low interest rates has propelled equity markets to record highs.
Now we face other – unique – economic conditions because of the pandemic including supply chain malfunction and a severe labor shortage. These two factors combined, along with historically low interest rates, lead many to portend runaway inflation. Economists and investors alike have been wrong – repeatedly – when trying to predict the direction of interest rate changes for the last 40 years. This record should make anyone reticent to try and forecast. But given the current low rates, it seems likely that rates will increase or at least stay the same, rather than decrease. Instead of worrying generically about potential hikes, it is worthwhile to drill down on what inflation and increased rates mean for the economy, and specifically for our investors.
Why raise interest rates now?
The Federal Reserve has a dual mandate of maximizing employment while maintaining price stability. Inflation is a catalyst that necessitates an increase in interest rates. But measuring inflation is a complicated and difficult task that takes place over time. It isn’t clear whether current inflation readings are “transitory” or related to bottlenecks or signs of an overheating economy. The risk of inflation running too high means a significant devaluation in the purchasing power of each dollar. We do not know what inflation will do in the future, but we do know that the current data is showing elevated levels relative to recent history, and that means the Fed may increase rates over time.
How this affects Heron Bay and its investors:
1. When we value a company with the intent to buy (or to sell) equities, we look at that company’s cash flow. A company’s valuation can be derived from the cash flows that it is expected to generate in the future, reduced into current dollar terms. When interest rates rise, the discount rate at which future cash flows are discounted increases, and therefore makes each future cash flow less valuable today, reducing corporate valuations.
2. To increase business value, businesses take on expansionary projects, funded by internal cash flows, issuing equity, or taking on debt. Rising interest rates increase the cost of capital for companies, cutting into profitability. This negatively affects valuation as well.
3. Increasing interest rates marginally improves the attractiveness of savings instruments relative to risky assets. If you have an opportunity to park cash in CDs or money market accounts that are earning 3% or more, you might be less likely to invest in equities. Outflows from equities result in broadly lower equity prices.
Quality as a concept in investing
Investing is as much about what you don’t own as what you do. Indexation provides exposure to broad markets, holding small weights in all the underlying companies within that index. Stock picking, by contrast, is deciding to hold equities disproportionate to underlying weights within the index. At Heron Bay Capital Management, we concentrate our portfolios around companies with enduring characteristics that support cash flow generation, which we define as “quality”:
1. We prioritize equities that generate strong cash flows now, not those that expect larger cash flows in the distant future. Current cash flows reduce speculation and increases accuracy within our valuation methodology.
2. We focus on businesses with superior economics that are less debt laden. These companies can continue to grow because they can fund much of their own growth internally.
3. Ben Graham famously said, “in the short-term the market is a voting machine, but in the long-term it is a weighing machine”. This suggests that a business’ fundamentals are what matter in the long-term. Quality businesses make for attractive investments due to their competitive advantages and ability to compound capital.
We hope that this adds some background and context to the topic of interest rate changes and inflation and how we address them in our portfolio management. At this juncture, many equity investors have financially benefitted from historically low interest rates. While we cannot know what interest rates will do long-term, we will continue to manage a portfolio of high-quality businesses positioned to outperform peers in their respective industries. We remain strong believers that our process-oriented approach is one that will generate positive results for our clients over time.
We thank you for your trust and continue to strive to provide you and your family with value and education.
Heron Bay Capital Management, LLC (“HBCM") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where HBCM and its representatives are properly licensed or exempt from licensure. For current HBCM information, please visit the Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov by searching with HBCM’s CRD #305537.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. All investments include a risk of loss that clients should be prepared to bear. The principal risks of HBCM strategies are disclosed in the publicly available Form ADV Part 2A. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
The model performance shown was created by HBCM utilizing Portfolio Attribution within Factset for each investment portfolio listed. The model performance shown is not indicative of future performance, which could differ substantially. It does not reflect actual account performance for any specific client or a composite performance for a group of clients. Model results represent what an investor’s returns might have been, had they been invested in the exact investments using the exact same allocation for the exact same time period for the model portfolio reflected. This does not reflect the impact that material economic and market factors may have had on decision making. The results shown were achieved by means of a mathematical formula.
Actual returns will be reduced by investment advisory fees and other expenses that may be incurred in the management of the account. The collection of fees produces a compounding effect on the total rate of return net of management fees. The applicable fees are described in Part II of the Form ADV.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.