The Secret Winners Of Declining Interest Rates
The Secret Winners Of Declining Interest Rates
Are Compounders and Serial Acquirers Still Worth It?
Much has been said about the market distortions created by a declining and then zero interest rate environment. One is however overlooked.
A common take among value investors and libertarian-leaning commentators is to see them as responsible for the emergence of tech monopoly and overall inefficient capital allocation.
By providing money “for free”, it has kept alive zombie corporations, given unlimited capital to bloated conglomerates and tech giants, and overall financed the casino economy we live in.
Of course, it also allowed for public debt and overall green & DEI madness to go on unpunished.
At the same time, the very same groups are deeply enamored with stocks of “compounders” and “serial acquirers”, due to the outstanding long-term performance of these investments.
But I believe they are very misguided to believe this will be true in the future.
The End Of Buffett’s Playbook?
The rationale behind pushing for buying high-quality compounders is the one pushed by Warren Buffett and the late Charlie Munger is that as long as the ROIC is high (ideally large double digits), your returns will be fine in the long run.
There is a lot of truth in this argument, and it made Berkshire the $1T giant it is today, with purchases like Coca-Cola or American Express decades ago.
Some key elements of the modern “Buffett Doctrine” beyond the general value investing principle are:
You should bet on America.
Industries dominated by monopolies or oligopolies are highly profitable (credit cards, tech, banking, processed food, etc.)
Invest in large corporations (to be fair, in part due to the sheer size of Berkshire Hathaway).
Buy large insurance corporations to leverage their float into extra cash for investing.
Moderate leverage usage.
The importance of moat and brands.
This differs from the strategy of for example Peter Lynch, which prioritized smaller stocks, in unloved industries, with long runaways for growth.
In my opinion, Lynch practiced a more “pure” form of contrarian value investing. He would also sell a lot quicker when the discount was not there anymore.
Buffett instead has been pursuing a strategy that benefited from the progressive hollowing-out of the US economy.
The goal of Berkshire’s investments is actually (far more than admitted by Buffett) to maximize rent-seeking from corporations acting as middle-men and “tollbooth” of the actually productive economy:
Credit card processors.
Banks, insurance, etc.
Broadcasters, media, advertisement. (Sirius)
Telecom
Tech giants with rent-seeking monetization methods (Apple once it had a mature app store).
On top of it come a few addictive products, like alcohol and sugary drinks.
Not all these companies are pure rent-seeking activity, but when they are not, they are monopolies/oligopolies able to extract more from the broader economy than they would if exposed to true competition.
Almost all are also active in very tightly regulated industries, where lobbyism, corruption, and collusion with politicians help create and defend the monopolies industry structure.
The goal here is not to target Buffett but to question if the so-called compounded, truly excellent rent-seekers, can keep up this performance in the future.
The Role Of Cheap Money
By now, it is pretty clear to all honest observers that the US (and Western at large) economy is hollowed out by special interest, rent-seeking and corruption.
Why make good weapons or spaceships when you can get DoD contracts anyway (Lockheed, Boeing)?
Why keep innovating when you can squeeze the entire mobile ecosystem (Apple)?
Why invest carefully and intelligently when you can take risky bets and let the taxpayers foot the bill (banks, insurance)?
A key factor in creating this situation, and almost entirely undiscussed, has been too low interest rate. The process goes as such:
Larger, more connected corporations get access to lower capital than their competitors.
They alone can use this cheaper capital for a few actions:
Acquire smaller competitors with cheap debt.
Break sub-sections of the market with year-long losses, to bankrupt competitors.
Rinse and repeat in new segments until most competitors in most sub-sectors are bankrupted, kicked out of the market, or acquired.
Rise prices continuously, as consumers/clients have no alternative left.
It is worth noticing that even for smaller, actually innovative companies, the same phenomenon plays out in a low-rate environment:
Build an actually good product using raised (cheap) money.
Keep raising as much money as possible as fast as possible to outrun the competition.
Build a monopoly in your niche through the aggressive growth financed by 1-2 decades of losses, produced by selling below costs.
Exploit the built monopoly and rent-seeking to give money back to investors.
The End Of Cheap Money
When you understand the phenomenon above, you get why it was profitable to invest in massive, rent-seeking tollbooth companies.
The cheap money allowed for continuous growth and industry consolidation, leading to higher margins for the rent seekers, and lower productivity for the whole economy.
The problem happens when these corporations meet rising interest rates.
This triggers at once several deadly obstacles:
No cheap debt means buying profitable smaller competitors becomes expensive.
Massive accumulation of debt suddenly matters and interest now eats money needed for R&D and capex.
No additional cheap debt means no ability to finance share repurchase keeping stock prices afloat with artificial bids.
Serial acquirers are also following a similar playbook:
Buy companies in the same or unrelated industry with cheap debt.
Industries keep consolidating, helping rent-seeking behaviors. Better if you are an active actor in the consolidation, like a franchise chain buying all the independent restaurants, garages, plumbers, dentists, etc.
Built scale so you can save on overhead, branding, etc.
Larger sizes mean even cheaper money, so keep buying forever with ever more debt, after all, interest only goes down when you need to roll the debt, right...
Internal Rot
Not being able to wrestle out more efficient competitors is a problem, the consequence of easy cruising for decades is another additional problem.
No competition, corruption, and complacency have a deadly effect on complex organizations, as we discussed recently.
For example, Boeing is not even (yet) endangered by scrappy smaller competitors. But simply by dangerous designs, corner cutting, low-quality manufacturing, etc.
The Currency Reserve Role
A lot of these issues were tolerable for the last 3-4 decades because the US owned the dollar, the world’s reserve currency.
As such, it could progressively destroy all its physical productive activities, especially manufacturing, with only subsidized farming and oil&gas surviving today).
They would be replaced by a globalized version of domestic rent-seeking, with employees of tech giants and financial institutions extracting value from the rest of the world. Any refusal to comply would be met with devastating sanctions or outright invasion.
Fake Economy
This also means that a lot of the US economy could tolerate the rent-seeking, as it was financed by a massive trade and fiscal deficit. These deficits would in turn pay people to do economically unproductive activities as :
federal employees/bureaucrats, military (especially high-pay consultants and contractors, more than the “grunts”), bankers, lawyers, marketers, NGO activists, politicians, etc.
If most of the economy “feels” fake, it’s because it is.
The growth of these activities, as well as speculative bubbles, would also finance the blue-collar “servants” of the newly minted “intellectual upper class” with too much money on their end and endlessly pursuing status-seeking spending:
house builders/craftsmen, cleaners, Uber drivers, landscapers, house flippers, wedding planners, luxury hotel workers, drug dealers, prostitutes, etc.
The Western economy has turned into essentially rent seekers living of accumulated capital and money printing. Or people selling the rent seeker services.
The production of actual goods is for the third world, clothes from Bangladesh, minerals from Africa, food from South America, manufacturing from China/SE-Asia, etc.
Moving Forward
Moving forward a few factors will have fundamentally changed.
Each factor will act on damaging the previous winners (rent seekers, compounds, and serail acquirers) so beloved by value investors.
Rising Rates
The rising rate will make most acquisitions not profitable. It will also wreck corporations with too much debt on their balance sheet.
Either the rollover of debt will cripple their finance and ability to reinvest. Or it will bankrupt them outright.
Chinese Competition
Rent-seeking works well only if you can stay protected from real competition. Consumers will happily buy the cheaper, better alternative if they have one.
With the globalized US-centric economy, competition was not an issue.
But now, cheap and high-quality Chinese EVs, drone, semiconductors, software, planes, solar panels, batteries, etc. are “flooding the market with overcapacity”.
What flowing means here ACTUALLY means cutting price in half with superior products.
This is a mortal threat to the likes of GM, Ford, BMW, Boeing, Intel, Amazon, Facebook, Google, which have not innovated in 1-3 decades depending of the company.
No wonder the US Congress got the memo from their owners sponsors and push legislation on its returns like:
End Chinese Dominance of Electric Vehicles in America Act of 2024
Protecting American Agriculture from Foreign Adversaries Act
Protect America’s Innovation and Economic Security from CCP Act
No Foreign Election Interference Act - Foreign Grant Reporting Act
To prohibit the Secretary of Homeland Security from procuring certain foreign-made batteries
Hong Kong Economic and Trade Office (HKETO) Certification Act
The first bill's name says it all: "End Chinese Dominance of Electric Vehicles in America Act of 2024". Yet all Chinese EV makers combined must have something like less than 0.1% market share in the US... For instance BYD, China's largest EV company, has literally never sold a single passenger vehicle in the country and doesn't plan to: no wonder if Congress already legislates to "end their dominance" when they're not even there
Multipolarity
Moving forward, the abuse of sanctions will make the privilege of getting real manufactured goods in exchange for printed paper fade away. Slowly, but inexorably.
This is how it (the dollar) ends, not in a bang but a whisper.
This will be a good thing, as it will make unproductive activities fade away as well, replaced by domestic manufacturing and less income & wealth inequality.
If the crisis period can be passed successfully, this will do more to defuse US social and political tensions than anything else.
How To Invest In This New World
Atoms Over Bits
An obvious and constantly repeated theme of my analyses is the importance of rebalancing portfolios toward real assets.
This includes commodities (oil, food, metals, etc.) but also manufacturing, or even real estate in areas not in a bubble for whatever local reason.
This is because the fake, financialized economy, born in the 1990-2000s is not dead yet, but is bleeding to death by a thousand cuts:
Slow de-dollarization.
Deglobalization.
Collapsing productivity & internal rot.
Rising competition from Chinese firms.
Declining rule of law.
The social and political consequence of maximizing rent-seeking:
Exploding inequality.
Drug abuse and deaths of despair.
Political polarization.
Mass immigration.
Activist hysteria disconnected from reality (climate, gender, etc.).
Invest Globally
Another theme is internationalization, as the new productive companies can be located in China, Indonesia, Africa, South America, etc.
Different jurisdictions might be more risky in a period of international tensions and war. But declining domestic jurisdictions are not the answer as well.
The answer is looking for returns so high that the occasional issue is compensated by gains somewhere else.
Get paid for your risk!
No more 1% dividends from Western pharmaceutical or tech companies.
But 10-20% dividends +5-10% buyback from foreign firms instead.
Beware The “Compounder”
Lastly, as you gather, what is currently a heresy for value investors is to avoid the Coca-Cola-style compounders.
The same holds true for MacDonalds, Goldman Sachs, Apple, Google, etc.
It might take generations before we see again such durable expansion of global brands.
This is because, in the short and medium term, we will not see rising a cultural hegemon like the 1950s USA.
China will rise, but not reach the same dominance. Neither will Russia, India, Indonesia, Japan, etc.
Where To Invest?
Each emerging block will consolidate its own ecosystem of local car manufacturing, search engines, social media, messaging apps, marketplace, fintech, energy production, etc.
So what will matter is a cheap enough stock price, good profit distribution habits, and a large enough LOCAL/REGIONAL market.
It is also worth noticing that most of the world will not completely lock itself away Soviet-style, so money will still flow between jurisdictions.
The only ones at risk of complete Sovietization are the USA+ Europe. If you have a lot of money, a trading account in Singapore, Hong Kong, or Dubai is probably worth it.
Along these guidelines, the ideal hunting grounds will combine growing quality /climbing the value chain + large population + cheap energy.
Together, they will form the basics of future profitability for real assets production and investor returns
Where to find it?
China
Russia (if accessible to you, like for Asian readers)
SE-Asia
Bonus to Indonesia in particular for its population size.
South America
Bonus to Brazil in particular for its population size.
Central Asia
Somewhat lacking in quality and real growth (as in “not driven by population growth”), but potentially making it up if prices are cheap enough:
India
Africa
To avoid because of too high geopolitical risk is the Middle East (see upcoming report for a detailed explanation).
Commodities’ Exception
This excludes commodities, which are likely to stay globalized because a barrel of oil is just too fungible.
So invest in commodities wherever you like the geology + price + jurisdiction.
As the ultimate cyclical, commodities should be looked on a case-by-case basis.
I made the argument for oil, gas, tungsten, food, and coal before.
You can probably add in order of potential: antimony, titanium, platinum-group metals, iron, rare earths, silver, lithium, and uranium (yes uranium is at the very last, barely making the list, because it is very hard to invest in).