Companies Successfully Navigating Higher Interest Rates

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Chris Davis:

Interest rates act like gravity on all valuations. They act on real estate, they act on private equity, they act on PE multiples. So interest rates, the long-term bond being in the fives or mortgages being in the sevens is a huge different than the ming and the twos or threes. It is just a massive, massive change, and it takes a long time to roll through a system because debt is termed out and it rolls over relatively slowly. But our basic assumption is that we will not see 0% interest rates again, and that that was the anomaly, that the pressures on the cost, instead of calling it interest rates, and we call it the value of money, we would argue that the value of money is being diminished by the fact that we're printing more of it than we're taking in. And so we're continuing to increase the money supply and therefore devaluing each individual piece of paper.

And so how that plays out, how we. Now, having said that, I want to just give the caveat, certainty is a very dangerous thing in this business, and there are scenarios where the advent of AI could reduce certain costs like healthcare inflation and things like that in a way that could be dramatically positive and be ultimately deflationary, pro-growth, but pro-growth through productivity rather than through inflation. So we're open-minded, but yes, we expect that on average in the next decade, interest rates will be higher than they were in the last decade.

Danton Goei:

Some of the ways that we think about insulating our companies, one obviously is pricing power,

Ensuring that they do have that pricing power and be able to pass it on. And we just look historically, have they been able to do that? What is the competitive environment look for them? How important is their product to their customers? Two, our companies have very strong balance sheets and low leverage. That is just one thing that we put at the very top of our investment analysis is the strength of the balance sheet. And so if the cost of debt goes up because interest rates are rising, we think on balance our companies will do better because they have such strong balance sheets and often don't have any debt. And then finally, our companies are generally profitable today earning strong cash today. They're not expecting earnings to be strong in seven to 10 years. And those type of business that are expecting earnings far in the future are worth less when the discount rate is higher, when interest rates are higher, because in the meantime, you could be earning a lot more if you had that money today instead of waiting seven years for it.

Chris Davis:

In terms of financials, we had a dress rehearsal to what interest rate spikes can do to different financials, and you got to see who was swimming without a bathing suit. And our investment in companies like Capital One and back then JP Morgan and of course Wells Fargo, they were all positioned conservatively, which is what we would expect. They weren't taking big interest rate bets. There were others, some very flamboyantly like First Republic and Silicon Valley Bank, but even some well-known banks that clearly had a lot more exposure. And so in banking, you can get mark to market issues on the balance sheet. The deposits don't mark to market, so you can get a lot of pearl clutching when there are changes, but we always look through at the fundamentals and whether it's an indication of a management being conservative or aggressive.

We've always had this enormous bias in financials towards the conservative side, which is why we never owned a share of First Republic or Silicon Valley Bank.

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