With the era of easy credit behind us, asset managers will be rewarded for fundamental analysis. It’s a skill set that calls for commitment and patience. Written by Christopher K. Hart, CFA
A return to a more normalized interest rate environment after last year’s hectic pace of rate hikes by central banks likely will bring about a shift to active investment strategies that focus on uncovering value in companies through fundamental analysis. This marks a tectonic change in financial markets where, for over a decade, returns were heavily driven by zero interest rate policy, or ZIRP, and thematics, while actual fundamentals and commensurate valuations were often ignored.
Interest rates are expected to remain elevated this year, but even when the U.S. central bank reverses course and cuts borrowing costs it likely will not return to a zero-interest rate policy after seeing the resulting inflation and societal effects. Amid this normalized moderate-rate environment, traditional corporate financial theory should be back in vogue. Valuations now should top investor considerations, and investors ought to eschew businesses that showed inconsequential cash flow and relied on low-cost equity to prop up top-line growth.
The campaign to contain inflation has been a global effort, albeit delayed until inflation in many areas was rampant and proven not to be transitory. Last year, central banks for the ten most heavily traded currencies, the European Central Bank, the Bank of England, the Bank of Canada, and the Swiss National Bank, conducted a total of 54 rate hikes over 12 months.
That wave of rate increases heralds a return to an investing approach that calls for a more circumspect look at a company’s business model (income statement) and cash flow statement. Market participants with this mindset likely will have observed how companies with simply top-line growth saw an exaggerated appreciation in value while never generating a dime in free cash flow. At the same time, many lower-growth businesses that created strong, sustainable earnings with supporting valuation metrics were overlooked amid the low-rate euphoria.
Efforts to shore up the global economy with fiscal policy – on top of the easy credit conditions and essentially free equity – helped amplify distortions in how low- and high-multiple stocks were perceived.
Companies with high multiples that were perceived to offer top-line growth, not necessarily generating earnings or growth in free cash flow, drew considerable investor attention during this period of ZIRP. Meanwhile, businesses with free cash flow, solid fundamentals and market-like levels of growth that traded at lower multiples were overlooked by participants enamoured with businesses many believed would-be disruptors. Investors failed to recognize that a low, risk-free rate that comes with easy monetary policy is just as beneficial for low multiple stocks as it is for high multiple stocks. Market participants who employed traditional fundamental analysis and Corporate Finance 101 theory would have readily recognized this mispricing.
The era of normalized interest rates likely will be challenging for passive investors, an oxymoron, as passive investing does not employ any of the tenets of investing, and it is sure to favour more experienced active managers who can sift through the noise and find a business with good fundamentals, business momentum, and attractive valuation.
Through qualitative bottom-up analysis, thoughtful value investors typically look for two or three catalysts that help improve a business in one to two years. Value investing requires accurately assessing cash flows through a careful analysis of financial statements and discussions with management to understand a business. It is a skill and involves a commitment that may have faded from the marketplace because the prolonged low-rate environment appeared to more readily reward passive styles that ride a tide of sentiment and arbitrariness rather than disciplined analysis.
Early in 2023, it’s reasonable to expect the Federal Reserve and other central banks to maintain high-interest rates and normalize into FY2024. As a result, this normalized monetary policy will likely continue to displace strategies not rooted in time-tested investing styles. This will take some time as the market is conditioned to expect another period of ZIRP.
Moving on past another Gilded Age facilitated by cheap money, the dominant investment strategy is sure to involve parsing balance sheets and cash flow statements to uncover value in underpriced businesses. Sifting through financials for undervalued businesses requires patience and commitment, an approach that may be a novelty to some investors.
Christopher K. Hart, CFA, is a portfolio manager for the Boston Partners Global Equity and Boston Partners International Equity strategies.
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