A new calendar year is often a natural point to both review and look ahead from an investing perspective. Upon review, this past year may mark a sea change in investor mentality, especially as the rising tide of low rates floating asset prices higher has seemingly reversed. If a business or project is worth the present value of the sum of all its’ future discounted cashflows, lower discount rates over years have successively increased the values of the same stream all else equal. Conversely, a higher discount rate (often related to interest rates) lowers the present value of the same stream. For example, a $1 perpetual dividend with no growth, valued at a 3% discount rate would be worth ~$33. The same dividend valued at a 6% discount rate is worth $17.
The new year has roughly coincided with the disappearance of the global aberration of negative yielding bonds after cumulatively peaking above $15 trillion over the past few years (for context Canada’s entire GDP is approximately $2 trillion). This may mark an inflection point in the market’s “there is no alternative (TINA) attitude” and an end to unexpected behaviours, such as paying to lend or paying taxes early to avoid negative deposit rates that the prior regime of low growth and easy monetary policy generated.
Source: Bloomberg
Not surprisingly, valuations of high-growth companies such as Beyond Meat have slid from being valued at 25x+ revenues to less than 5x recently. This is partially due to the impact the significant, and somewhat unexpected, rise in interest rates have had on the present value of future cashflows and valuation multiples. However, the CEO of Beyond Meat, Ethan Brown, may have also succinctly captured a key shift in market mentality during the company’s latest quarterly call, where he stated:
“What we have to do is change our mindset from one where it was growth above everything else to now pushing very quickly the business into a cash flow positive and a profitable position”.
Along with the de-emphasis of the “growth above everything else” mindset, 2023 will also bring with it a far less beneficial financing environment for businesses. Non-investment grade or higher risk firms will likely pay double or above 8% annual rates to borrow relative to the lows they enjoyed at close to 4% seen in early 2022. This should mean higher borrowing costs for many companies to both operate and invest. With government bonds increasingly offering a more compelling alternative than in the past, it seems logical that the market will be in search of investment alternatives that are profitable, cash flow positive, and capable of appropriately funding growth. Combined with the expectations of a recession ahead, it seems likely that there will also be less risk tolerance and market appetite for the more fragile businesses.
As a result, looking ahead we may be in an environment where active management and idiosyncratic or company-specific investment opportunities have a more prominent role in portfolio outcomes. Especially when coupled with the backdrop of elevated volatility relating to an uncertain economic outlook, and generally tepid earnings growth outlook for equities in North America.
One example of a business offering a differentiated profile may be QV holding, Headwater Exploration (HWX). Although not in a high-growth industry, Headwater is an early stage oil and gas exploration and development company with significant insider ownership. While the industry is not novel, Headwater maintains various attributes that distinguish it from the broader market. The company plans to self fund double-digit production per share growth, with 30%+ production per share growth anticipated in the upcoming year. Importantly, this growth profile is scheduled to be completed while generating excess cash, maintaining a net cash balance sheet, and paying a ~7% dividend yield. Importantly, its asset base in the Clearwater play supports some of the most efficient production in North America, which drives a lower environmental impact and cost profile relative to other peers.
Although the future is unknowable, over the long term, allocating capital to idiosyncratic or company specific investment opportunities such as Headwater should produce differentiated results over time.
