Why Inflation is Not Necessarily Bad for Growth Companies

The markets have taken a real tumble over the past couple of weeks however most of the tumble has been masked in the index because Big Tech has held up alright.  Overall though the breadth of the market is very weak right now and a lot of our positions are down significantly from their all-time highs.

What Are We Seeing in the Markets?

As I mentioned the breadth in the market is very deceptive right now.  On the surface, the S&P 500 is still pretty close to all-time highs.  However, when we analyze a little closer we can see that the performance this year has really been driven by a very small number of very large companies.  These companies are Apple, Microsoft, Nvidia, Tesla, and Alphabet.  Their strong performance this year has covered up the lacklustre performance of the majority of the rest of the companies. Another sign of this is that the FAAMG stocks plus Tesla now make up almost half of the overall Nasdaq index.

An interesting theme that’s taken root over the past month or two is that smaller technology firms with high growth are being punished particularly hard by the market and I think this is creating opportunities for us to look beneath the surface a bit. I believe the reason these smaller companies are being punished is that investors don’t have as much conviction in their business as they do in the larger tech firms which have just performed so well for so long. Sentiment might matter in the short term, but price paid and quality of the business is what matters in the long term. That’s why I think there might be some golden opportunities here if we can identify the right businesses.

Taking Advantage of Opportunities

What do we do in this situation?  I am refocusing in on quality assets.  Some of our positions have been indiscriminately sold because they are “growth” and the theory is that growth companies will fare worse in a high inflationary/rising interest rate environment because more of their value is derived from profits in the future.  While this does make sense from an academic valuation standpoint, this is not how a business owner would look at a business.  I am concerned with how a company’s BUSINESS will fare in an inflationary/rising interest rate environment.  As such I am looking for companies who have pricing power and low amounts of debt.  Almost all of our companies fit that mold.  Most of our businesses are not capital intensive and as such will not be as hurt by higher amounts of inflation.  And with very little debt to speak of, rising interest rates should not be a problem for us.

How to Value a Business

When I value a business I do not use bond rates as a factor to determine the appropriate prices.  Instead I use a 10% hurdle rate as my discount rate.   The theory behind this is that I always want to ensure at least a 10% return on our equities over time.  This means that my valuation does not change if bond yields rise because I am always using 10% as my discount rate.

Most of the financial industry does not value companies the way I do.  They instead will use long term bond rates as the discount rate as opposed to a 10% hurdle rate and as such, when bond yields go up, their valuations go down.  This means that in general stock prices are going to be negatively affected by rising interest rates.  There is nothing we can do about this HOWEVER, over the long term, if we are correct about our valuation of a business, then that will eventually bear out in the stock price.  This is because the long-term returns are not dictated by what prevailing interest rates are but how much CASH a business generates.

A good example of a company that I think will fare well regardless of what the inflation environment is Sea Ltd (SE).  SE is one of the largest positions in our portfolio and for good reason.  It is a three-headed monster with a gaming company, an eCommerce company, and a fintech company.  Based in South East Asia, SE is the largest company in South East Asia.  Their gaming company Garena is the creator of Free Fire which is currently being played by about 1 in 10 people on the planet. Their e-commerce company Shopee is dominant in South East Asia and has recently expanded in to parts of Latin America, India, and Europe, with positive initial indications.  Their fintech arm while still very much in a startup mode, has a ton of potential.  What’s more SE is situated in a market of 600 million + people in their core markets and those are also some of the most rapidly growing economies in the world.  As a result of all these tailwinds SE has grown their revenues by over 100% in the past year.

Why Inflation Doesn't Really Matter

Now do you think it really matters very much to the business of SE whether inflation is 2% or 6%, if their growth rate is 100%+?  The answer is no that’s not really a big risk factor.  The risk factors in a business like SE are whether or not they can achieve better profitability with scale, and whether they can outcompete their competitors in South East Asia, Latin America and elsewhere, or whether the popularity of their blockbuster hit game Free Fire will start to wane.  None of these actual risk factors has anything to do with inflation. So the fact that the stock is down about 40% from its all time high a few months ago should be a cause for reflection and analysis.  If the market is simply lowering the stock price because of higher inflation expectations, with no change in those business risks I mentioned above, then this is a massive opportunity to buy a great business at a relatively cheap price.

In selloffs like this in the market, the market is often not that discriminating in what gets sold off.  People get scared and they panic, or investors have to cover margin debts and so they sell the good companies to cover the losses on the bad ones. If we can stick to our convictions and focus on high quality companies, we can take advantage of these mistakes.

I fully expect that we have entered a period of higher interest rates and higher inflation.  I’ve been expecting this for a few years now and I think we are well positioned for it.  The market prices of our positions may be impacted in the short term, and perhaps even more so than the wider market because most of our businesses are high growth companies.  But this is not a reason to worry.  In fact this should be viewed as an opportunity which we intend to take advantage of.

- Craig White, BA, LL.B., CIM®

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.