This post is authored by MOI Global instructor Michael Melby, founder and portfolio manager at Gate City Capital Management, based in Chicago.
Mike is an instructor at Best Ideas 2022.
“It’s my money, and I need it now!” –J.G. Wentworth tagline
Readers might recall J.G. Wentworth television advertisements from the early 2000s where actors shouted from windows to encourage viewers to exchange their structured settlement or annuity for upfront cash. While J.G. Wentworth customers all needed cash on the spot, many investors today are often so flush with cash that they are doing the opposite.
Investors continue to lend their cash to the government in exchange for a historically low rate of interest and a promise to return the investment principal at maturity. Not only are investors relinquishing the opportunity to use their cash, but they are also accepting an interest rate that is currently well below the expected rate of inflation, ensuring a loss of purchasing power when their cash is returned.
Rather than agreeing to an interest rate that compensates the lender for both inflation and the time value of money, investors seem to be relying on the Federal Reserve for guidance regarding the interest rate they should be earning.
While individuals could continue to choose to lend money at interest rates below the rate of inflation for the time being, it is unlikely that this wealth-destroying behavior can continue in perpetuity. Given the choice between spending money in exchange for a basket of goods today or lending the money only to receive a smaller basket of goods in the future, most individuals would spend the money today. Consumers with access to credit have the additional opportunity to purchase durable goods such as new homes today by borrowing at low interest rates and repaying the loan in the future with inflated money.
As investors and economists ponder the path of future inflation, it is important to note that central bank policies continue to incentivize spending over savings. Individuals with excess cash or the ability to borrow will look to spend the cash now rather than wait for inflation to erode its value, further contributing to the short supply of goods and services. We find it highly unlikely that these utility-maximizing actions will prove to be transitory.
Our primary macro-economic concern is that market forces will eventually push interest rates higher, resulting in a reduction in lending activity and higher costs of capital for both debt and equity investors. While it would be extremely challenging to eliminate the risk that higher interest rates would have on equity markets, we continue to attempt to mitigate the risk when constructing our portfolio.
We invest primarily in companies with owned assets including, land, buildings, and equipment. This focus served us well in 2021 and should continue to benefit our investors if inflation exceeds expectations.
We also value all portfolio companies on a discounted cash flow basis and have maintained our required rates of return at 12.5% or higher even as long-term interest rates hover near all-time lows.
Historically, we have found some of the worst investment decisions result from either lowering required rates of return or relying on relative value analysis in an overvalued market. We look to mitigate the negative impact that rising discount rates could have on asset prices by maintaining consistent return requirements regardless of the interest rate environment.