Watching the interest-rate pendulum
THESE FUND MANAGERS SEE SIGNS OF A ‘PROFOUND’ CHANGE IN MENTALITY
The trend of declining yields has been in place for 35 or so years, and the only way something like that can happen, is if everyone is on board.
Central banks around the world have been lowering interest rates, and in many cases, bringing them to zero. Meanwhile, portfolios are loaded up with interest ratesensitive stocks, or bonds, that pay next to nothing.
It all makes perfect sense if you believe the narrative that it’s going to be this way forever. But for Andrea and Patrick Horan, portfolio managers at Toronto- based Agilith Capital, anytime investors hear the word “forever,” they should run from that strategy and take the opposite approach.
“It’s about trying to figure out where the pendulum is, where it is about to go, and how far it can absolutely swing,” Patrick said. “The nuance of this move higher in interest rates is the most profound thing we’ve seen since 2008 in terms of what likely will be a shift in mentality.”
Andrea and Patrick comanage the Agilith North American Diversified Fund, a long- short fund that has many of the same holdings as the Agilith Long Only Fund.
They were admittedly a bit early to the rising interest rate theme, as yields remained compressed for much of 2016 as a result of factors such as the surprise Brexit vote. But it’s certainly been working in the past couple of months.
One thing that’s occurred with the decline in rates, is a very sharp retraction in capex spending. “It’s been deliberate by corporations because if there isn’t any growth out there, they see no reason to spend,” Patrick said.
Instead, firms opted to do the safe thing and buy back shares, increase their dividends, and conserve cash.
However, the portfolio managers believe the market is starting to price in more growth and inflation, and a lot of the capex sitting on the sidelines will return.
They also noted that when yields are very low, it’s almost impossible for a company to understand what its future liabilities are in terms of pension costs, for example.
At the same time, properties, plants and equipment are almost deemed worthless in terms of asset value, because they can be replaced at a lower price.
“If you have no pricing power or deflation, then you don’t want to invest,” Andrea said. “All you are working on is saving costs.”
Yet in a rising rate environment, the managers explain that pensions can be measured much more easily, and hard assets become barriers to entry for competitors. This is one reason why they like the opportunities in manufacturing and industrials.
With a focus on companies that have strong free cash flow and good balance sheets, and short positions in names that need access to capital markets in order to fund their business plans, two long positions reflect the capex spending theme.
General Motors Co. and Martinrea International Inc. stand to benefit from a broader improvement in the economy, improved valuations for plants and equipment, and they happen to be cheap.
“GM has consistently outperformed and defied analysts’ expectations for a stall- out,” Andrea said. “It is a great cash generator, is intent on returning capital to shareholders, has a fantas- tic brand, and is shifting the product mix to a higher-margin business.”
Meanwhile, the stock still trades below seven times forward earnings.
Martinrea’s P/ E is even lower at about five times, despite double- digit growth and great cash flow, and it’s fallen recently due to concerns about the future of NAFTA.
Horan noted t hat t he company has international operations, with facilities in both Canada and the U. S., in addition to exposure to a very strong auto market.
“They also have the potential for margin expansion,” she said.
Martinrea is also one of the few producers of aluminum casting, both in North America and Europe, something that is key for auto manufacturers seeking to meet fuel standards.
“Martinrea is one of the few that actually add to the value chain,” Patrick said. “This is a case where nobody is valuing replacement costs at all.”
Another fund holding that should benefit from an increase in capital spending is Exfo Inc., a provider of testing equipment and services for wireless and wireline networks. It has a global presence, and benefits from the expanding Internet, as well as the race to build faster speeds for telecom networks.
“Exfo is one of the few companies that does it, and more importantly, they have a ton of intellectual property around these systems that is very hard to replicate,” Patrick said.
The managers consider the stock very inexpensive, as Exfo struggled with execution in 2014 and 2015. Yet it has been much stronger in the past year, and should benefit from the recovery in capex.