The Impact of Inflation and Interest Rates on Capital Allocation – An Interview

Martin Schwarz, CEO of Stern Value Management, pointed out in a 2021 article that soaring inflation could drive the risk-free interest rate (the 10-year Treasury bond yield) to 4% or more.

That, of course, has happened. And it means that a company’s project must provide a return that is almost 3% higher than a year earlier to add value.

“This is no longer a rounding error, but a potentially significant hurdle that will crowd out a lot of private investments, the type that tends to be more efficient and less wasteful,” Schwarz explained in his article.

He recently answered some questions from financial journalist Dan Weil about his current views on rising interest rates and high inflation and their impact on value investing. Here is what Schwarz had to say.

Question: What are the main problems that high interest rates and inflation are causing for corporate America?

Schwarz: The problems are the same as two years ago: capital allocation woes. The risk-free rate impacts the cost of capital. And that is determined by the return expected by shareholders for providing firms with funds to run their operations.

The higher the riskless alternative rate, the higher shareholders’ demands from riskier investments. If investors don’t expect those demands to be met, they will take their funds elsewhere. And that could deprive firms of the resources to fund future growth.

The “elsewhere” in this case could be the government bonds themselves, which provide a much more attractive yield than any time in the last 15 years.

Question: So where does that leave companies?

Schwarz: It leaves them with more limited access to capital and a higher hurdle rate on their investments. That will limit the viability of long-term projects--both organic and inorganic. The effect may not be felt in the near term, but it could be a problem in 5 to 10 years.

That’s when the lack of past investment will be apparent in dwindling efficiency and productivity, along with declining market share and pricing power.

Question: How will companies deal with the constrained availability of capital?

When faced with a dwindling portfolio of potential investment opportunities, firms may choose to hoard cash and wait for uncertainty and opportunity costs to go down. But with inflation at current levels, each dollar will be worth much less in 12 months.

With this in mind, companies will consider returning cash to shareholders via dividends or share buybacks (I explained the buyback strategy in a previous article). Companies may be reluctant to increase dividends given the highly uncertain future.

They fear the potential backlash if 12 months down the road they have to cut the dividend, given impact of a potential recession on their balance sheet.

Question: So that leaves companies with the option of buybacks?

Schwarz: Yes, that may be  the only viable capital allocation alternative. Yet it seems that government is intent yet again on making things worse, by taxing this alternative out of the realm of practical possibilities.

Share buybacks aren’t “immoral,” as some claim. They have the potential to add value or destroy it, depending on how they are executed.

Question: What is ideal execution?

Schwarz: Ideally, firms will issue shares when their stock price is high (so they can get more capital for fewer shares) and buy them back when prices are low. That’s buying low and selling high.

Doing the opposite is a terrible use of shareholder funds, a decision that will impact long- term value creation. Therefore, buybacks are an alternative that will add value only to some companies. The stock market overall isn’t undervalued at this point by most measures. So buybacks don’t make financial sense for many companies.

Question: So how should companies approach capital allocation in this difficult environment?

Schwarz: There is no one-size-fits-all strategy. Buybacks may be better suited for firm A, a one-off dividend for firm B, and an acquisition of a struggling competitor for firm C.

The answer for each company lies in having a robust capital allocation process. That’s one that will properly evaluate each decision on merit.

Question: Are many firms doing that?

Schwarz: Very few. Most firms may have a capital budgeting process that is somewhat strong, but that is usually the case only for organic investments. Dividend, share-buyback, and to a lesser (yet more troubling) extent merger-and-acquisition decisions are made on the fly.

The fact that senior management’s compensation is seldom linked to the outcome of these decisions only makes things worse.