How to pick stocks in an era of expensive money

One man’s terrorist is another man’s freedom fighter, and a company’s cost of capital is the return investors require to provide it with finance. The first statement is an overworked aphorism, the second is something stockpickers should heed. But why link them?

The reason has to do with ideology mingling with economics and political passions, entwined with the age-old debate over whether government largesse crowds out private sector investment. What’s not controversial is that inflation drives interest rates and the size of returns demanded by investors, making it more expensive for companies to raise capital.

A related question is whether the shift from an era of easy money and less flamboyant government spending to one of tighter monetary policy and fiscal stimulus will permanently affect how companies do business. One starting point is to consider whether increased public sector spending might prove inflationary – and what the implications are for private businesses.

Capitalism at an impasse

Much of the inflation since mid-to-late 2021 can reasonably be attributed to Russia’s invasion of Ukraine, as well as post-pandemic dislocation in supply chains and labour markets. But while consumer price index (CPI) data has fallen considerably from its peaks, markets are still nervous about inflation's path from here. There are concerns that getting core inflation back down to target will not be as straightforward as first hoped.

Central banks hinting that interest rates could be higher for longer isn’t a prognosis of structurally higher inflation, per se. But it’s fair for market participants to ask if this could be the ultimate outcome – and, if so, to ask what the cause might be.

Given the scale of government indebtedness since the pandemic – the US Federal government alone owes $32.8tn (£26.2tn) – old arguments made about public spending come to mind. And one assertion by monetarist economists in the 1970s was that actions taken by governments to fund their investment programmes hurt the private sector.

For example, in the view of Robert Bacon and Walter Eltis, the UK economy was held back in the 1960s and 1970s because a combination of high taxes and interest rates made firms reluctant to commit to projects. Effectively, the bloated state ‘crowded out’ private enterprise.

The alternative position, held by devotees of John Maynard Keynes’ worldview, is that government spending boosts aggregate demand thanks to the employment it creates. This in turn, Keynesians say, has a multiplier effect stimulating rounds of private spending and growth.

Also described as ‘crowding in’, one contemporary example might be America’s Chips and Science Act, a $53bn blend of tax credits, manufacturing incentives and R&D support designed to stimulate the strategically vital semiconductor industry. The White House, keen to back this interpretation, states that $166bn of private investments in semiconductors and electronics have been announced in the year to August 2023.

Modern economists characterise the role of government in industrial strategy differently. A working paper by University College London academics (Deleidi, Mazzucato and Semieniuk, 2019), titled Neither Crowding In Nor Out, stressed that specific issues of market failure do require intervention in some sectors. In the case of semiconductors, an over-reliance on Taiwan makes critical supply chains vulnerable to geopolitical tensions and arguably government should act to mitigate such risks when they arise.  

Whereas the Chips and Sciences Act was bipartisan, the Inflation Reduction Act (IRA) is larger and more controversial. It devotes $369bn – through grants, loans and tax credits – to green energy and infrastructure, as part of an overall package that also seeks to fund $300bn-worth of deficit reduction through increased corporation tax and more stringent enforcement of existing tax codes (although some of the unpopular increased funding to the Internal Revenue Service was rescinded following debt ceiling negotiations). On the IRA’s first anniversary in August, the White House declared $110bn in green investment projects had been announced, a much lower return on investment so far than for the Chips Act.

Financing the energy transition is an interesting case, however. One of the UCL authors, professor Mariana Mazzucato, has argued that government spending provides crucial leadership in new areas where private investment is slow to tread. Climate change, for example, could be characterised as the ultimate negative externality. The social benefits of meeting the challenge may be measured in millions of lives.

Musing on the question of whether the private sector is failing on emissions reduction is wandering into no-man’s land in the trench warfare of climate politics. Economically speaking, however, programmes such as the IRA are a leap of faith. One can believe climate change is real and man-made but also doubt the efficacy of huge state spending and restrictions on western behaviour while developing nations burn more coal. If, however, the innovation encouraged in the richest countries is exported and accelerates a global solution to the problem, it will be worth it.

Should output increase, energy capacity widen, and externalities reduce, it may well be that the IRA proves disinflationary. Early measures of success include hundreds of thousands jobs being created, but if those are ‘non-jobs’ and aggregate supply isn’t boosted, then problems such as a tight labour market and weak productivity will exacerbate inflation.

Why does this matter for UK investors, whose own government has shown less willingness to roll out such spending plans? For starters, the size and importance of the US Treasury market – which is sensitive to inflation and government spending – means the rates investors can get on US government debt affects the valuation of assets on capital markets throughout the world. When the de facto global risk-free rate is high, shares everywhere must offer better returns to be attractive.

For an index such as the FTSE 100, home to companies moving past a cyclical peak in profitability and which are in industries with weaker long-term prospects, this dynamic can be among factors depressing valuations. On the plus side, it makes the UK a hunting ground for value stocks if the naysayers have it wrong.  

Is big government a big problem for investors?

Uncertainty causes investors to demand higher returns, so the prospect of the capitalist system undergoing a significant change is bound to have an effect. And if the market is unsure how inflation and real growth are to be affected by gargantuan state intervention, rates won’t fall rapidly.

That affects companies because the terminal rate of interest is the floor under their cost of capital and is ultimately set by the market, not just central bank policymakers.

As one of the world’s foremost experts on valuation, professor Aswath Damodaran of Stern University, New York, puts it: “I know that in the last decade, it has become fashionable to attribute powers to the Fed that it does not have and view it as the ultimate arbiter of rates. That view has never made sense, because central banking power over rates is at the margin, and the key fundamental drivers of rates are expected inflation and real growth.”

So far in fiscal year 2023, the US Federal government has spent $1.61tn more than it has generated in revenue. Over the nine months to July 2023, the deficit grew $887bn compared with the same period a year earlier. These figures place the $300bn deficit reduction targeted by the IRA in context.

Being able to create US dollars, the world’s reserve currency, means default on debt obligations is unlikely (shenanigans over future debt ceiling negotiations withstanding). But borrowers understandably demand a higher yield from US Treasury bonds when the government is so spend-happy. Importantly, even as the lagging measure that is headline CPI data moves down, there will still be upwards pressure exerted on interest rates if factors such as labour market conditions conspire to keep inflation expectations elevated.

Damodaran is among those who see the difference between the yields of 10-year US Treasuries and 10-year Treasury Inflation-Protected Securities (Tips) as a market-imputed inflation expectation rate. It indicates that in 2022 investors expected long-run inflation of around 2-2.5 per cent, compared with 1-1.5 per cent in the prior decade. In September 2023, that spread is still running in the higher end of those ranges. When central banks caution not to expect the cutting of policy rates too soon, it’s because they’re following the debt markets.

Shares are affected in two ways. Firstly, the cost of money influences companies’ capital structures, as well as highlighting the consequences of past choices. Secondly, the yield on government bonds plays a fundamental role in setting the fair value of share prices – part of the symbiotic relationship between implied total returns and cost of capital.

The importance of capital structures

From the perspective of a business, the central idea of capitalism is that raising finance allows the rapid increase of scope and scale, ratcheting up the ability to deliver goods and services, which it aims to do at a profit. For their part, investors forego the utility of spending money now because they reasonably believe they will get back more, and with greater purchasing power, in the future if they back the success of a business or venture.

The cost of capital can be thought of as the inducement, in terms of future cash flows, that a company must promise investors in exchange for funding now. This cost varies between firms depending on the type of finance they raise, with capital structures being a mix of debt and equity.

The market interest rate is the base level of compensation investors expect for the opportunity cost of tying their money up. Lending to governments of countries like the US, Japan and the UK is considered free of default risk, so any borrowing by companies, which cannot just create money to meet their obligations, must offer a spread over sovereign bonds with the same time to maturity.

To reiterate crowding-out theory, the government's high demand for money is a factor pulling up rates, and if there is a fear government spending is inflationary, that will be a factor, too. With 10-year US government treasury bonds yielding 4.3 per cent, that puts quite a floor under the costs private borrowers must pay. As a result, they may be put off debt markets and simply decide to avoid investment in new projects.

When debt finance is cheap, the tax incentives to borrow make it an attractive option, which enables companies to lever shareholders’ funds and achieve a higher return on equity (ROE). Debt-ridden businesses are often described as bloated but, in a low interest rate environment, companies that make use of this source of finance are considered to have a ‘lean’ capital structure.

Prudently run businesses are wary of too much financial gearing, however. Shorter-term loans and credit facilities usually have floating interest rates and longer-term debt – mostly bond issuance – while typically fixed interest in nature, must be refinanced at maturity. This subjects the borrower to prevailing interest rates and credit conditions, which may have become – as we have seen since 2021 – far less benign.

Companies and public bodies alike loaded up on term funding when debt was cheap, but analysis by Morgan Stanley highlights the shadow being cast by a ‘maturity wall’: $5.3tn of public bonds and institutional loans from American, European and emerging market borrowers will need re-financing before the end of 2025. That figure is equivalent to 26 per cent of the value of bonds tracked by investment-grade and high-yield indices.

The high-yield (ie, lower credit quality) part of the bond market could face difficulties on this front, according to Morgan Stanley. Furthermore, businesses that relied on financial engineering in the credit markets – for example, leveraged loans – would be hit if there was any retrenchment in the willingness of specialist providers to finance them.

Highly rated borrowers are indirectly affected by the travails of those lower down the credit quality ladder. Slowing economic activity at the tail end of the credit cycle feeds into generally weaker growth and profits. There’s also a drag on cash conversion as customers take longer to pay invoices.

In any case, even if it proves manageable for larger companies, the rising interest expense of a debt-heavy capital structure starts to weigh on profits and free cash flow. Aggregated, all these factors encourage de-leveraging over investment.

The cost of equity

Equity finance is more expensive to raise than debt, in part due to fees, and it costs the company more over time: whereas bonds just pay a pre-determined amount; with equities, proceeds of the business are shared.

Success belongs to shareholders, but the flipside is shouldering the risk of a company underperforming. Should the company go bust, creditors have a senior claim to any assets in administration, a reason bonds are less risky than owning equity in the same company.

It is not uncommon for preference shares to feature as part of a firm’s total equity. They tend to be issued at a premium to the market price of ordinary shares. Dividends are paid at a specified rate and, although they can be deferred, must be prioritised (plus any arrears) ahead of payouts to ordinary shareholders. Although they should be considered in a firm’s overall cost of capital, preference shares are far less significant in number than ordinary shares.

Theoretically, a share price ought to represent the sum of all future cash flows an investor expects, discounted to today’s value. Discount rates must also reflect a premium over the return that could be earned risk-free by holding a quality government bond and receiving the cash flows to maturity.

As we saw in 2022, when interest rates go up very rapidly – at a rate faster than that at which companies can improve their earnings outlook – the only way returns from share prices can meet the requisite discount rate is by falling. From a company’s perspective, if it were to try to tap stock markets for finance when its share price is depressed, the amount raised for a stake in its future cash flows is lower, making the cost of equity higher.

Existing shareholders are understandably wary of new share issues for this reason. That said, when the share price is high, a good deal on finance put to work profitably is beneficial.

Stockpicking in the era of expensive money

All of this can boil down to some metrics of which investors should take heed. Having taken account of the cost of elements of its capital structure, a company’s weighted average cost of capital (WACC) is its breakeven hurdle rate of return for future investments. For prospective shareholders, the relationship between WACC and the return on invested capital (ROIC) is important.

The ability to deliver a high ROIC, which is calculated as net operating profit after tax (NOPAT) divided by average capital employed, is an important quality to look for. Companies for which ROIC is consistently above the WACC create enormous economic value for shareholders.

Upward pressure on WACC raises the bar for all companies, which means businesses must have strong competitive positions and, crucially, pricing power to protect margins in response to higher costs. It is also prudent to be aware of the degree of operating leverage a company has – profits of companies with a lower proportion of fixed costs will be more resilient to any fall in sales.

For investors, this implies a strategy of focusing on quality companies as core holdings. But this must of course be weighed up against valuation risk. It can be tough to get to grips with what is good value in the new interest rate regime, as companies may appear cheap against their recent history but expensive versus government bonds.

Ultimately, growth is the answer – companies that offer this prospect will always stand out. And this is why government subsidies that help pick winners and losers are contentious. Either you believe nations are embarking on a moon leap towards prosperity that markets are afraid to make, or the unintended consequence will be innovation buckling under taxes and the higher cost of money.