General

Q3 2022 is dominated by macroeconomic headlines. The followings jump out:

1. UK gilt 50 year topped 4.6% (source: everywhere)
2. The £ crashed to almost parity to the $ (source: everywhere)
3. US Treasury yield closed in on 4% (source: everywhere)
4. 30-year fixed rate mortgage in the US crossed 7% (source: everywhere)
5. Some desperate wannabe homeowners in the UK are willing to pay 10% to fix their mortgage for 10 years (source: FT)

Needless to say, the macroeconomic headlines point to something that looks like a paradigm shift, in a very abrupt manner.

The discount rate is going up!

That said, one of my portfolio’s companies have reiterated their views that long term, interest rate will stay low-ish, at around 3-4%. This is Brookfield Asset Management who said that.

Which I do somewhat agree to… long term, interest rate will probably stay slightly below the long-term average of 4.5% and hence should be pretty good for businesses overall. It will also imply a real yield that is positive, rather than negative as it is now and as it has been over the last couple or so years.

For it to stay low-ish however, central banks will need to tame inflation.

Some positive signs have been observed in the States, including a flat or 0.6% m-o-m growth in inflation in July and August.

My view is that when mortgage rate more than doubled over the last 6 months, this should tame inflation significantly as it would slow all the purchases one would need to form a household.

Outside the US, the UK made major headline in the last 2 weeks ending Q3. The £ dropped to near parity, and interest rate shot up more than 250 basis points since the start of August. I won’t reiterate what the UK Chancellor announced here but I’m observing market developments around it with great interests.

Overall, with rate in the UK hit 4%, and the US bond yield also nearly hit 4%, I’m debating hard as to whether I should revise my discount rate of 6% to 8%, to maintain the desirable margin of safety.

This will have an implication, in a major way, to how I see things at their fair value.

Compounding maths indicate that if one’s discount rate is 6% and one forecasts long-term growth of 2%, then a productive long-duration assets should be priced at a fair value around 25x their normalised earnings. (1 divided by 6% minus 2%).

So if the discount rate goes up to 8%, and long-term growth rate remains at 2%, then the same asset should now be priced at only around 16x their normalised earnings.

To get back to 25x in an environment where discount rate is 8%, the long-term growth rate has to become 4%. How many businesses can one think of that will grow at 4% forever?

This academic geometric maths play itself out very well YTD with the S&P, as it’s got repriced from a PE of 25x earlier this year to now around 18x.

In any event, if interest rate continues to hover at 4% next quarter I will start increasing my discount rate from 6% to 8%.

This very change in my discount-rate assessment does play a role in why I haven’t established any new positions in a major way despite the come down in stock prices. Had the discount rate stayed unchanged the current level of stock valuation would have enticed major top up/purchases.

That said, generally speaking, as rate goes up so does return expectation and the attractiveness of stocks as an investment overall. I therefore maintain my policy of drip feeding the portfolio with my monthly savings.

Portfolio updates

There have been no major updates to the portfolio’s companies’ operational performance. I’m eagerly waiting for the Q3 2022 results and will summarise them in my Q4 write up.

Book

The book I’m reading this quarter is “More from less” by Andrew McAfee.

The book does such a good job describing how human ingenuity, the capitalistic system and technology arguable created one in a 300,000 year event that capitulated human civilisation to a new height in terms of living standards.

It does objectively highlight the effects on the environment that come with this change and encourage us to “step on the pedal” to accelerate our efforts to tackle these challenges.

The book is a treat for the optimist, a well-researched book for the realist and could be a mind-set changer for the pessimist.

I hope you will enjoy the book!