Inflation and the Value Fund

“Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett

As we will state many times, we are not macroeconomic investors. We do no try to predict the market because we do not think it is possible, as a result, we do not try to time our investments, however, the last few weeks have been a very frantic time in the market. There have been three recent macroeconomic developments:

• Firstly, the Federal Reserve of the United States (US central bank) commented that they will likely increase interest rates in 2022, and the market is of the view there will be several interest rate hikes in the next 12 months starting in March when the Federal Reserve next meets.

• Secondly, The US reported January 2022 inflation of 7.5% putting the current inflation rate at a 40 year high. The high inflation is bad for an economy on its own but further increases the expectation of interest rates increasing rapidly in the next 12 months.

• And lastly, the White House reported that they anticipate an imminent attack on Ukraine by Russia.

All this news has spooked the market and it might be a rough year ahead as investors and especially speculators deal with uncertainty and anxiety. We, therefore, thought it prudent to give our view on the matters above.

Russia & Ukraine

Let us start with Russia invading Ukraine. There are just too many unknowns here for us to even attempt to analyse the situation:

• Will Russia invade Ukraine?

• If so, how will Europe respond?

• How far is America willing to go to support Ukraine?

• How involved will China get?

• How long will the war last if an invasion does occur?

• How will this disrupt supply chains?

The list of questions goes on and on and your guess is as good as ours as to what the right answers are. What we do know is that economies will continue to operate, and businesses will continue to supply goods and services as best as they can. We have dealt with markets that have been through extreme hardships such as Egypt during the Arab spring, Zimbabwe during periods of hyper-inflation, and Nigeria during its foreign currency shortages. Our experience has taught us that even in harsh environments a business can survive and some even thrive.

We take the long view when investing and believe that by picking high-quality businesses they should be able to withstand the shocks of the unknown. The portfolio is made up of such companies and our cash on hand allows us to take advantage of continued market weakness by either buying more of these businesses or looking for other opportunities.

Inflation and rising interest rates

High inflation leads to increased interest rates and the stock market doesn’t like either for the following reasons:

• Inflation implies that prices for various goods are increasing and increasing pricing puts pressure on consumers resulting in them either purchasing fewer goods or trading down for cheaper alternatives both of which can be bad for producing businesses. Inflation also results in a higher cost of supplies and raw materials for those businesses which means lower profit margins.

• To combat high inflation central banks must raise interest rates, which the Federal Reserve is expected to do this year. Higher interest rates are good for interest-earning assets such as bonds. Stock exchanges do not do well in high inflation periods as investors move their money to safer, high-yielding bonds. (It is important to note that just because the share price of a company declines does not mean the economics of that business also declined)

• Higher interest rates put pressure on businesses with substantial amounts of debt. Their interest payments increase which in turn decreases profits. The bull markets of the last several years have led to some extraordinary valuations for businesses that either don’t make a profit but the market believes they will or have huge amounts of debt due to access to “free money” during recent periods of historic low interest rates, or have both high debt and do not make a profit. Investors will not hesitate to exit these companies if the perception is that they are overvalued, or they will not grow as anticipated. This is already happening with several big tech names which in turn is dragging the market down with them. Our opinion is this is long overdue, it does not make sense to have loss-making companies with enormous amounts of debt trade at 20x revenue.

The good news for us is that we are long-term investors, therefore, are not overly concerned about the short-term. High inflation and interest rates for a year or even more do not bother us if we are clever about where we put our money. We use a value investment philosophy which entails investing in high quality business that are trading at discounts to their intrinsic value and often their peers. Buying companies trading at discounts decreases the probability of share prices declining as rapidly as the market during periods of extreme pessimism. Buying high quality businesses increases the probability of these businesses weathering a storm allowing us to buy more of these businesses when their share prices do decline. Furthermore, we typically avoid business with excessive amounts of debt relative to their market capitalisation or earnings reducing the chances of these business running into debt problems during times of economic tightening. And lastly, over 50% of the Value Fund is sitting in cash, this gives us the ability to wait things out and take advantage of truly exceptional opportunities.

Conclusion

Overall, we believe we are comfortably positioned if inflation remains elevated and for when interest rates do increase. However, we expect the market to remain manic, trading up one day and down the next, because of most people’s short-sightedness. It is during these times that it is especially important to keep a long-term focus, to invest in a business with solid fundamentals that can do well in an expanding economy and gain market share when the economy tightens. Patience is key as we believe our investments will outperform over time even if their share prices trade down in the short term. And finally, we are NEVER afraid to hold a portion of our portfolio in cash so that we can pounce on opportunities when the market becomes truly fearful!