As an investor, one of the most critical skills to possess is adaptability. The world of finance and investing is constantly evolving, and being able to adapt to changing circumstances can make the
difference between success and failure.
One of the most significant changes investors have faced recently is the shift from a low-interest and low-inflation environment to a high-interest and inflation environment. For decades, interest rates and inflation remained relatively stable, with central banks around the world keeping rates low in an effort to spur economic growth. However, over the past few years, interest rates have started to rise, and inflation has picked up the pace, leading many investors to wonder how to navigate this new environment.
The first step to adapting as an investor in this new environment is to understand the changes that are happening. In a high-interest and inflation environment, the cost of borrowing money goes up, making it more expensive for businesses to borrow and invest in growth. This can lead to slower economic growth, lower corporate profits, and lower stock prices. Additionally, as inflation rises, the value of money declines, making it more difficult to maintain purchasing power over time.
Given these challenges, it's crucial for investors to adjust their investment strategies accordingly. For example, in a high-interest environment, investors may want to focus on bonds and other fixed-income investments that can provide a steady stream of income. However, they will also need to be aware of the risks associated with these investments, such as interest rate risk and credit risk, and ensure they are adequately diversified. Just look at what happened to the regional banks in the US. At the same time, investors may want to consider investing in commodities such as gold or oil, as these tend to perform well in inflationary environments. Additionally, they may want to look at sectors such as real estate, which can be a hedge against inflation due to the potential for rental income and appreciation in property values.
Another important consideration for investors is the impact of high-interest rates on debt. Higher interest rates can make it more difficult for individuals and businesses to service their debt, which can lead to defaults and bankruptcies. As such, investors should be cautious when investing in companies with high levels of debt, as they may be more vulnerable in a high-interest environment.
As an equity investor, you need to change what you look for, as growth does not have the same value as one year ago. If a company grows 10% and inflation is 10%, the real growth is actually 0%. Therefore it is more important to look at the margins in this kind of economy, and as mentioned above, the financial net and debt position are probably the most important to keep an eye on in a company’s financials. Growth, market share, and the total addressable market are not as important as one year ago. Of course, it is still important for a company long term.
Investors need to shift their focus when it comes to equity investment in a high-inflation environment. A company's growth, market share, and total addressable market are no longer as important as they used to be, as the real growth could be zero when the inflation rate is high. Instead, investors should pay closer attention to gross and profit margins, free cash flow, and net debt position. With rising inflation, gross margins are under
pressure due to the increased cost of materials, while higher salaries, external services, and financing costs affect profit margins. Therefore, focusing on profits is essential instead of EBITDA and EBIT.
Although profits and earnings can be manipulated for a period through accounting, cash flow provides a more accurate picture of the company's financial situation. Determining if the company needs more funding is
crucial, especially in the current environment, where investors are no longer investing in long-term growth stories is crucial.
Lastly, investors should check if the company has a net cash or net debt position, with the former being preferable in a high-interest environment. It's also essential to consider the interest coverage ratio and net debt to EBITDA, particularly if the interest rate is fixed or variable. Investors should be cautious of bonds that need refinancing in the near future as interest payments may increase significantly, affecting the interest coverage ratio. Therefore, past interest coverage ratios may not be a reliable predictor of future coverage ratios.
Returning to the topic of growth, it's essential to examine the factors driving it. If growth is solely driven by price increases without any corresponding growth in volumes, it's considered low-quality growth. The situation worsens if the volumes are declining, and price increases merely compensate for the lost volume, constituting the entire growth.Therefore, it's crucial to remember that all growth is not of the same quality.
In conclusion, adapting as an investor in a high-interest and inflation environment requires a willingness to adjust investment strategies to reflect changing market conditions. This means being aware of the risks and opportunities associated with different asset classes, maintaining a diversified portfolio, and being prepared to make changes as needed. By doing so, investors can confidently navigate this new environment and achieve their long-term financial goals.
For more articles like this subscribe to my substack: