Bill Chater, Investment Specialist, Baillie Gifford
It’s said that high interest rates spell the end for small cap investing, but do they have to?
You or your clients’ capital may be at risk.
Fears of regime change – from accommodating monetary policy, plentiful resources and geopolitical stability to higher cost of capital, constrained resources and prioritising productivity over growth at any price – have contributed to the present valuation gap between small (e.g. businesses with a market capitalisation below $5bn) and large-cap businesses. Currently, small-cap equities look at historically cheap levels relative to large, reversing a decade-plus trend.
The prevailing narrative attributes the recent ups and downs in the stock market almost exclusively to central banks aggressively hiking interest rates. Further, we have heard suggestions that the higher interest rates and accompanying increase in the cost of capital are prohibitive to investing in early-stage companies. It’s assumed that when interest rates go up, earlier-stage smaller companies will be less attractive to investors who will want to put their money into investments which offer greater short-term certainty.
We question, however, whether this relationship is as simple or robust as many would have you believe.
Partly, our thinking is formed by looking at previous interest rate increases and the subsequent performance of US small caps in the aftermath. Historically, small-cap investing has worked in periods of higher central bank rates. While the aggressiveness of today’s hikes may be usual, the actual numbers are far from it. In similar conditions, historically, shares in smaller companies have prospered (eg the Russell 2000 index returns in the three years following 1986, 1994 and 2004 fed fund rate increases).
So, higher rates are not in and of themselves terminal to smaller companies investing.
Instead of myopically looking at one factor, we’d argue that a confluence of stressors has prompted the current volatility. The cumulative shocks of a pandemic, inflationary pressures, and yes, a monetary pivot as central banks have raised interest rates, but also escalating geopolitical tensions and not being able to pinpoint where we are within the economic cycle have led to a paralysed and shell-shocked market psyche.
Amid this much uncertainty, investors’ horizons have shrunk to the point that they are unwilling, or perhaps unable, to consider organisational developments or proposition enhancements at a company that do not positively impact returns in the next 12 to 18 months.
We readily admit that this is not a prosperous environment for our investment style. As long-term investors, we typically consider a company’s relevance over at least five years. We are used to having a longer horizon than most, but we cannot remember when it felt this extreme. Being a long-term investor in small, growing, disruptive businesses currently feels powerfully contrarian.
But this will ultimately pass. Partly as shocks work through the system and partly due to innate human adaptability. We will return to an environment more sensible of the underlying worth of the company.
In the meantime, with such blatant dislocation between the long-term business potential and current market price, this environment presents opportunities for our portfolios.
Business building, not valuation model tweaking
The market price for any equity can be broken down into projected earnings or cash flows and what the market is willing to pay for these at that given time (variously described by its price-to-free cash flow (P/FCF), price-to-sales (P/S) ratings or price-to-earnings (P/E) multiple).
We have always invested in businesses where the scale of the opportunity and their ability to execute are much more influential on our terminal projected value – what we perceive the implied value of a company to be beyond our five-year investment horizon – rather than how much higher we expect the multiple to rise.
Investing over the timeframes we do, the skill is judging the scale and likelihood of future cash flows rather than financial mathematic gymnastics. Moreover, the eventual growth of cash flows swamps any possible rating changes.
A quick look at a discounted cash flow model, which seeks to value a company based on its expected future cash flows, speaks to this. This calculation is much more sensitive to a percentage change in the terminal growth expectation, the constant rate at which a company is expected to grow forever, versus a percentage change in the discount rate.
But more powerfully, this is a lived experience with our most successful investments. Analysis has shown that most investment returns can be attributed to operational growth. To the extent that the multiple could have shrunk by 70, 80 or 90 per cent from the initial investment and still delivered an attractive two-fold return. Even in today’s environment, such multiple compression would be an extreme and frankly unlikely occurrence.
If we do our core task adeptly – identify immature, high-potential, progressive businesses early in their relative lifecycle and hold them for the long term as they scale and grow – the resulting sales and earnings growth should entirely swamp the market multiple or rating and deliver attractive returns.
Operational impact
Within our approach, the more pertinent question is the operational impact of any changes to the investment environment and whether it influences a holding’s ability to generate future cash flows. Crudely, this can be broken down into:
- Does the business have the financial resilience to navigate the near term?
- Is there a material impact on the business’s long-term growth potential and returns profile?
Capital is now less plentiful, and funding for earlier-stage businesses is scarcer. Still, we are observing that capital remains available for companies demonstrating strong operational performance (shown by recent capital raises by Axon, Alnylam Pharmaceuticals, QuantumScape and Ocado). But markets now need to see progress before companies can access additional funding.
We do not think investors should shy away from owning unprofitable businesses. The market is currently discounting these, but many of our most successful holdings have initially been cash-consumptive and unprofitable (eg Tesla).
Growth requires investment; this has always been a fundamental principle of business building, and we continue to support it. We hold such names on the understanding that they are making investments now to improve the likelihood of future profitability. For businesses at this stage, we examine:
- Are there observable positive unit economics, eg revenue per unit of sales less cost of goods sold, which speaks to how the business could generate future positive earnings?
- Do they have the capital to progress to a self-sustaining point of maturity or to a sufficient point to unlock additional capital?
These are fascinating, high-potential early-stage businesses; precisely because of the market’s presently fearful approach, we should look for opportunities to be optimistic and greedy.
The next question is – does the changed environment impact the portfolio’s ability to generate growth? No business operates in a vacuum; all have a greater or lesser connection to where we are in the economic cycle and general patterns in consumption. Yet primarily, our holdings deliver growth by taking advantage of long-term growth trends.
Bluntly, the changes in market sentiment over the past three years have not reduced our need for improved patient outcomes, better efficiency in health care or clean energy. Indeed, the current push for greater efficiencies seen in many sectors suggests that investment themes, such as automation or enterprise digitisation, should be all the more necessary and important.
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Bill Chater, Investment Specialist
Bill is an investment specialist dedicated to our Smaller Companies strategies. Prior to joining Baillie Gifford in 2018, Bill studied for an MBA, specialising in Finance, at the University of Edinburgh Business School. Previously, he spent five years with Mastercard, as a client account manager for institutional clients. Bill graduated MA in History from the University of Edinburgh in 2012.
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