Forget trying to predict timing of interest rate cuts – just buy solid companies with gain potential
These two smaller companies offer capital return as monetary policy becomes more accommodative
Every investor seems to have an opinion on precisely when interest rates will commence their much-anticipated decline. Some think the Monetary Policy Committee will begin to cut Bank Rate over the next few months. Others are more cautious and anticipate that policymakers will wait for inflation to return to its 2pc target before adopting a more dovish stance.
In Questor’s view, interest rates are almost certain to fall this year. Estimating exactly when they will be cut, though, represents an inefficient use of time. An infinite number of wholly unpredictable variables can affect inflation, economic growth and, therefore, Bank Rate. Furthermore, correctly predicting the exact path taken by interest rates is unlikely to be particularly beneficial to long-term investors. The existence of time lags means it will take many months for their impact to be fully felt.
As a result, investors are better off accepting that interest rates cannot be accurately forecast. Instead, they should ensure their holdings can overcome today’s temporary economic challenges and are well placed to capitalise on an improving long-term outlook that is catalysed by a more accommodative monetary policy.
For example, our inheritance tax (IHT) portfolio holding in Michelmersh continues to offer long-term capital growth potential. The brick manufacturer’s trading update showed it remained on track to deliver full-year results which are in line with previous guidance in spite of a tough operating environment.
The company is poised to benefit from a continued fall in inflation, with rapidly rising costs having previously contributed to a two percentage point decline in its operating profit margin in the first half of the 2023 financial year. A lower rate of inflation, alongside impending interest rate cuts, also means the cost of living crisis is in its latter stages. This should equate to improved consumer confidence, which is already on an uptrend, that leads to greater activity in the construction sector and higher demand for the business’s products.
In the meantime, Michelmersh’s financial standing is sufficiently sound to allow it to overcome the current period of economic stagnation. Its net cash position increased by 19pc to almost £12m in the first half of the year, while a diverse forward order book further de-risks the business.
Following their recent surge, the company’s shares have risen by around 17pc since being added to our IHT portfolio six years ago. The FTSE Aim All-share index has fallen by 30pc over the same period, which equates to a 47 percentage point outperformance. Since the stock currently trades on a forward price-to-earnings ratio of around 10, further capital growth potential is on offer as the company’s operating environment gradually improves. Hold.
SDI, which is another of our IHT portfolio holdings, is also experiencing a tough operating environment. The manufacturer of products used in digital imaging applications released half-year results last month that included a profit warning.
While revenue edged higher versus the same period of the previous year, pre-tax profits declined by 43pc due to destocking and weak demand from China and Germany. The firm also suffered from the expiry of lucrative Covid-related contracts. It now expects pre-tax profits to be between £7.9m and £8.4m for the full year versus previous guidance of £9.8m.
Encouragingly, the company’s financial position remains sound. Its net gearing ratio stands at 46pc, while net finance costs were covered 4.5 times by operating profits in the first half of the year. This should allow it to continue with an acquisition strategy that was a key reason for its addition to our IHT portfolio just under a year ago.
Indeed, the firm purchased temperature sensor manufacturer Peak Sensors for £2.6m after the end of the first half of its current financial year. With asset prices being relatively low at present, its business model of acquiring small, overlooked companies seems sensible ahead of a likely improvement in their performance amid interest rate cuts.
Since being added to our IHT portfolio in January 2023, SDI’S shares have declined by 51pc and lagged the FTSE Aim All-share index by 36 percentage points. While this is clearly a hugely disappointing performance, the company’s long-term growth outlook remains intact. It deserves time to deliver on its potential. Hold.
‘The company is poised to benefit from a continued fall in inflation’