What now? More than 80% through what has been one of the worst overall years for investing in decades, investors look around at a changed landscape of higher interest rates, slowing growth, and elevated inflation and wonder how to position for the year(s) ahead. Should you take advantage of higher interest rates and lock in risk-free US Treasury Notes and Bonds? Are there stocks that have come down in value so much that they are buys here no matter the uncertain economic climate for the year ahead? At Arrival Capital, we have been thinking about these questions and now suggest a way to approach the investment world as it is -- find cash flows for sale at remarkably good values in both stocks and fixed income and reposition your portfolio to take advantage of the cash that will come in and the valuations that will recover as interest rates and inflation stabilize in the months ahead.
Cash flow is key for the reason it is always key -- generating cash returns is the reason why for-profit businesses exist, from the smallest store on Main Street to the largest tech companies on the planet. Future positive cash flow is why you start a business and why you invest in one. Sure, sometimes, in a time of low inflation and near-zero interest rates, investors get carried away with future prospects and throw money at other metrics like revenue growth, or total addressable market (TAM) or even just a good "story." But that time has passed and investors of all types need to return to first principles:
Predictions about future returns are far from perfect, but otherwise much of the above is basic math. You can make reasonable assumptions about how much a business should grow, you can factor in confidence intervals as to how likely your predictions are to come to pass, and finally, knowing current interest rates, you can discount the future cash flows to determine worth today. But if investing were just a question of math, everyone would just plug in numbers and get the same return.
There is a wildcard in investing that depends on the behavior of other investors (and business people in general). Specifically today, the behavior in question is fear. At other times it is greed. But 2022 has been a scary time for investors, net worth and net asset values have declined, sometimes dramatically. Long time solid stories in technology have suffered a collapse in investor confidence.
This level of fear and herd behavior have exacerbated declines in investment values that would still have occurred because of the increase in interest rates and greater uncertainty about future profits. But as anyone who has witnessed the dramatic swings in prices of even the most exceptional businesses can attest, the stock market values of businesses have in many cases been driven down much more than a sober assessment of future growth or interest rates should have produced. That is why we can find cash flows on sale.
These stock discounts exist in a variety of businesses today. Of course, some are found in certain hard hit technology stocks. But industrials, retail, healthcare and materials companies have also fallen and are slated, even under the most pessimistic glare, to produce profits in the immediate years to come that should produce meaningful gains to investors as stock prices recover to more properly discount the future. Arrival has for most of the past year been building client positions in these types of companies and industries, such as in Caterpillar (CAT) and Deere (DE), Eli Lilly (LLY) and Ulta Beauty (ULTA), all up dramatically from their 52-week lows even as many higher multiple technology darlings are still making new lows for the year.
Any discussion of cash flows today needs to also consider bonds. This has not been the case for more than a decade as central banks kept interest rates artificially low. Bonds became a place to warehouse capital not really invest it. That is not the case today as interest rates have risen dramatically. Arrival Capital has been taking advantage of rising rates to purchase US Treasury securities at rates around 4% and higher and we believe that these may prove to be particularly good investments in the near term as interest rates (and inflation) potentially crest and start falling in the year ahead. Other fixed income might also satisfy stringent risk vs. reward analysis and become valuable parts of diversified portfolios.
As we sit here on Halloween 2022, we can take a minute to enjoy the fun scariness of costumes and ghoulish decorations. But for many investors, 2022 has indeed been a truly scary experience. It is frightening to see portfolios decline in value as familiar longtime holdings careen downward. But fear is not an advisable investment strategy, even in the worst of times. At Arrival Capital, we focus on helping clients put fear aside and instead look for opportunities which, these days, meaning finding investments likely to generate meaningful cash flows from profitable businesses yet selling at cheaper valuations than were to be found in "better" times. If you would like to find out more about our approach, please take a look at http://arrivalcapital.com. And Happy Halloween!