With the Fed cutting rates last month, how is the team thinking about interest rates? Are there certain industries or sub-sectors that you think will benefit from falling rates?
It's natural to think that the companies hurt by higher rates will benefit from lower rates, but it really depends on the backdrop driving that change in policy. An example would be banks. Lower rates would reduce their funding costs, improve valuations within their security portfolios, and likely stimulate demand for loans. In a lower-rate environment, companies are more willing to borrow and invest.
Another sector that comes to mind is large, durable goods, like housing – things that are typically financed. But again, it depends on the economic backdrop driving rates lower, and it is the job of investors to understand the other factors that could be at play.
What will you be looking for as companies report third quarter earnings?
As always, a lot is going on in the world. The Fed has begun its easing cycle, many companies over the last 6 to 12 months have talked about weakening consumer spending, geopolitical tensions have remained top of mind for investors, and in recent days, ports have shut down on the East Coast. With all these external factors in mind, it will be interesting to hear how companies navigate these issues. I'll be listening for the companies that don't bring these up. We like to see companies that can absorb all these ripples through the global economy and continue to perform well. I’ll be listening for internal initiatives that companies are reinvesting in, whether that's new products, geographic expansion, or acquisition opportunities. We like to see companies investing for future growth through all types of economic backdrops rather than being reactive to what's in the headlines in the here and now.
Could you touch on the state of valuations across the equity markets? Where are you finding the best opportunities?
If you bring up valuation charts for the S&P 500 or other broad, market cap-weighted index, we are back to 2020-2021 highs. But if you look at the equal-weight S&P 500, we are roughly in line with the average over the last decade or so. In general, further down the market cap spectrum, valuations are more attractive. There are two areas where we are finding opportunities, and in this past quarter, we added to positions, including testing measurement instruments and one company related to the housing sector.
You mentioned earlier investing in companies that can absorb a wide range of external shocks. What does that look like right now?
We want to see companies whose products or services naturally increase in price without them having to negotiate with their customers. A great example would be payment companies, whose revenue, for the most part, is based on nominal payment volume, so it naturally grows as the value of goods and services purchased increases. We also see this with an insurance broker we own in the portfolio. As the value of all the tangible and intangible assets in the global economy rises, so does the cost to insure them. Insurance brokers are, in some ways, a toll on global insurance premiums. So, they benefit from that as well. Alphabet (Google), which we’ve owned for a long time, is a large player in digital advertising. As the price of a company’s products or services increases, it will likely invest more in marketing, and Alphabet naturally benefits from that.
Another area would be what we call a cost-plus business. Rather than having to absorb higher costs into their own cost structure, these are companies that can pass those costs right along to customers. We own a large HVAC and plumbing distributor, for example. When the manufacturer increases the price of those units, the distributor naturally passes that along to their customers so as not to absorb it in their own cost structure.
The last example I will point out is companies with high gross margins. If the cost of the widget you’re producing is becoming more expensive, if you have a higher gross margin, you can more easily absorb that cost increase into your cost structure than if you were to have a low gross margin.