How To Invest In A Low-Interest Rate Environment

For most, the result of investing in a low-interest rate environment may easily mirror the effect of mixing alcohol and prescription medication. The cocktail is dangerous and the hangover can put investors in the proverbial hospital for a long recovery.

When interest rates are at extraordinarily low levels, asset values can be pushed to extremes. And when the growth rate of total market capitalization outpaces GDP for extended periods, investors are virtually certain to face disappointing returns when interest rates eventually rise.

The reason is simple. The opportunity cost of choosing to purchase bonds and stocks becomes exaggerated. In the mind of the main street investor, the choice between bonds and stocks generally becomes a non-choice. "Stocks return way more than bonds so why would I buy bonds?" Low interest rates make all assets more expensive — home prices, farms, and equities. As interest rates rise, bond prices will fall, and the prospect of investing in bonds further drags on the mind of the investor.

As investors chase yield, they collectively bid up the price of stocks among each other. Prices are pushed to ever higher levels as more investors fear missing the upswing. The fear of missing out leads would-be investors to pile into the market and further exhaust the problem. When prices rise faster than the rate of real earnings growth, bad things are bound to happen.

What Is the Investor to Do?

Debt and equity cycles are very long. The institutional imperative is often to act when the best action is to sit on your hands. In November 1999 and again December 2001, Warren Buffett provided an analysis of the market facts described above.

The simple answer is to not join the crowd, conserve investible cash in treasuries, and continue to hunt for material mispricings in the market. The market will always create opportunities to acquire businesses selling at a material dislocation from their underlying value. Rising prices will allow this to occur less frequently, but it will occur.

The process of acquiring a whole business is the same process of investing in one: hunt for bargains, don't overpay. Adjust your expectations of the near term if the facts presented by low interest rates mean real returns will be reduced in the distant future.

What About Business Owners or Managers?

Business owners may face a different set of options. Decisions should mirror opportunity costs between internal and external opportunities.

• Lower return projects should be dusted off and re-evaluated against every other available disbursement of cash.
• Opportunities to produce more future earnings from the business may present returns greater than what can be achieved in the market.
• Early repayment of debt should be evaluated against all options. It is wholly appropriate to make advanced principal payments on expensive debts if refinancing is not an option.
• Captive rents — real property or equipment that is leased — should be evaluated for purchase over leasing. Low interest rates combined with cash flows set by a previous rate agreement will make the argument for inappropriate multiples difficult for any seller.
• Lease term refresh — an advanced refresh of lease terms for equipment should be aggressively pursued as interest rates are likely to revert to mean levels in future timeframes.

Perhaps best of all options comes to businesses that have the ability to redeploy capital in the future by borrowing in advance of need. The cost of funds, while undeployed, presents little material risk or loss of future purchasing power with proper terms. Funds can be paid back if unused.

In contrast to the dearth of investing opportunities during periods of low interest rates, the availability of cheap capital may materially magnify opportunities to deploy funds favorably as the tide runs out and interest rates rise.

One important qualification: the safety of an investment when using borrowed money bears equal scrutiny to using house money. Managers should not take more risk because of capital raised. Overpaying adds risk for investors and business owners.

Investors and business owners serve the same functions — expanding opportunity cost and using available capital to produce the greatest return. Waiting for fair prices only costs time.