Finance Your Budget How to understand how lower interest rates affect shares

How to understand how lower interest rates affect shares

Retirement shares.
If you plan to invest in stocks, you need to understand the effect of lower interest rates. Photo: Getty
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The very real prospect of interest rates being lower for longer is a kick in guts if you rely on income from fixed interest.

But it represents pennies from heaven if you buy the correct listed stocks, and if you’re planning to invest in shares, you really need to know why.

If you subscribe to the consensus view that interest rates will be lower for longer, then what you really need to understand is the impact they will have on the ASX-listed companies you’re interested in.

By getting your head around the overarching dynamics between interest rates and listed companies, you’ll be much better informed about which ones to own for the longer haul.

For starters, in an environment of lower-for-longer interest rates, all asset prices receive an uplift.

It’s not rocket science – within a low-interest-rate environment, companies simply have what’s called a lower expense ratio.

From an accounting perspective, this means less interest expense on a company’s profit and loss statement, and this can find its way to the bottom line – and potentially greater profits.

Company value and interest rates move in opposite directions

However, what many within the financial services sector struggle to explain, says Montaka Global Investments’ CIO Andrew Macken is that by far the bigger effects come from what’s called A) the applied discount rate on future cash flows, and B) that lower interest rates result in higher earnings multiples.

When thinking about the discount rate on future cash flows, adds Mr Macken, imagine you could put your cash into a term deposit and earn 4 per cent.

In this world, a company yielding, say 5 per cent in earnings annually is OK, but not great given the increased risk you are taking by investing in a company.

“Imagine now the term deposit rate falling to just 1 per cent. All of a sudden, the 5 per cent earnings yield company is much more valuable in this low-interest-rate environment,” Mr Macken said.

“This is why the value of companies goes up when interest rates go down.”

That’s because lower interest rates tend to have a more magnified effect on stocks that are growing faster – aka growth stocks. This means the more growth a company has, the greater the upward push on its asset prices.

“As a result, investors should really focus on long-term, sustainable growth stories,” Mr Macken explained.

“Companies that can grow their earnings sustainably over the long term have the potential to significantly increase in value in today’s low interest rate environment.”

Some workings to help you understand

Here’s a simple, yet useful example to illustrate the magnified effect that lower interest rates have on growth stocks.

Imagine a stock increasing its earnings at 1 per cent annually.

In a 4 per cent interest-rate world, its P/E ratio should be around 12x. But in a 2 per cent interest rate world, its P/E ratio should be around 16x.

To put it another way, this stock is worth around 33 per cent more if interest rates were to fall from 4 per cent to 2 per cent.

Need further explanation of the nexus between interest rates and individual companies?

Think of it, suggests Mr Macken, as simply the ‘opportunity’ cost of capital.

For example, $1 in your hand today is worth more than $1 in your hand in a year’s time, because you could have invested that dollar and earned a return in the meantime.

“The higher the return you can earn on that dollar, the lower the value of the future dollar. And vice versa when interest rates are low,” Mr Macken said.

“When the opportunity cost of investing is low, the higher the value of the future dollar.”

New interest rate paradigm

It’s equally important to remember, Mr Macken adds, that any asset is priced on the cash flows the asset will generate, and is discounted back, courtesy of the function of interest rate levels into the future.

But if interest rates were merely low today, and back up to historical levels next year, he also reminds investors there would be no real change in asset prices.

However, that’s no longer the case, and this is a really big deal.

“What signalled a major turning point in 2018 was the slow and steady realisation by market participants that interest rates are increasingly likely to remain lower for longer, and we’re now talking decades,” Mr Macken said.

“In that context, what really matters is the long-run, interest-rate expectations – five to seven years and beyond – and not simply what the Reserve Bank does to rates today.”

Companies most likely to benefit from lower-for-longer interest rates, says Mr Macken, will be those with higher growth projections, clean balance sheets – ideally with net-debt to equity below 30 per cent – and sustainable core earnings.

“Growth stocks carrying a lot more debt also stand to benefit, as the cost of borrowing will be lower for longer, and fair multiples will also go higher.”

The multiplier effect

This is how lower interest rates impact growth stocks.

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