‘Old normal’ vibes: Evenlode’s Yarrow considers historical interest rates as context for investing in successful companies given today’s modest UK equity market valuations 

Hugh Yarrow, fund manager at Evenlode Investment 

An eighteenth-century gentleman or lady wouldn’t miss a beat if presented with an interest rate of 5.25%. From the Bank of England’s formation in 1694, interest rates have averaged 4.7%. During periods in the modern era when rates have stood at this sort of level, inflation has often also ticked along at a reasonable clip. But shares of companies have generally posted real returns over sensible holding periods. Since 1900 and 1970 respectively, for instance, here are the numbers.ⁱⁱ 

The real ‘news’ in terms of the current interest rate environment is the rapidity of the rise. Last January, UK base rates were only 0.25%. This rapid change is not British exceptionalism, but part of a global trend. Rates in the US, for instance, have been on a very similar trajectory, with the federal funds rate now standing at 5.25% – 5.50%. 

Less frothy 

When interest rates are low, history has shown that pockets of financial markets can get frothy. As the economist and journalist Walter Bagehot noted in 1852, the archetypal Englishman John Bull ‘can stand a great deal, but he cannot stand two per cent’. When interest rates fall to such a low level, there is a danger that investors respond by taking greater risks. As Bagehot went on, ‘people won’t take 2 per cent; they won’t bear a loss of income. Instead of that dreadful event, they invest their careful savings in something impossible – a canal to Kamchatka, a railway to Watchet, a plan for animating the Dead Sea, a corporation for shipping skates to the Torrid Zone. A century or two ago, the Dutch burgomasters, of all people in the world, invented the most imaginative occupation. They speculated in impossible tulips’. 

There was no tulip bubble in the 2010s, but as rates have normalised over the last couple of years some glitches in the financial ‘matrix’ have emerged. Issues with cryptocurrencies, FTX, NFTs, Silicon Valley Bank and Credit Suisse can all be loosely collected in this category. More generally, highly leveraged structures are significantly riskier when interest rates stand at 5.25% rather than 0.25%. 

One can advance an argument that the removal of excess froth from the financial system has a cathartic, healthy dynamic. In the fullness of time, it should benefit sensibly run companies with sensible capital structures. 

Modest valuations a comfort 

More mundanely, the rise in interest rates has provided another option for savers, which has presented a headwind for equity valuations over recent months. There is now an alternative in the form of interest from cash or bond yields. Within the UK stock market though, we are reassured by how modest valuations appear when viewed from the perspective of longer-term history. Not unrelated presumably, to how downbeat sentiment is towards the UK stock market (and has been, really, for the last few years). 

Taking a specific example, consumer health and hygiene company Reckitt Benckiser has returned a cumulative +678% over the last twenty years, compared to +277% for the FTSE All-Share. Its current year Price/Earnings (PE) multiple is 17x compared to a PE multiple of 18x twenty years ago (and an average PE of 20x for the period as a whole). 

And here’s another. Test and measurement company Spectris has returned +1,235% over the last twenty years, also compared to +277% for the FTSE All-Share. But its current year PE multiple is 17x compared to a PE multiple of 20x twenty years ago (and an average PE of 17x for the period as a whole).ⁱⁱⁱ 

Neither company is of course perfect (there is no such thing), but they both expect compound growth to continue over coming years. As Spectris management recently put it, ‘we expect to deliver organic growth consistent with our medium-term objectives of +6-7%, alongside strong progress on expanding margins, as we drive forward with our ambitions to be a leading sustainable business’. 

Though these are nice examples, there are many holdings in the Evenlode Income fund for which valuation has either subtracted from, or not meaningfully added, to the attractive long-term compound returns generated by fundamental growth and dividends alone. The use of patience and fortitude in the act of capturing these long-run fundamental returns sums up the ‘get rich slowly’ approach. 

As the investor Peter Lynch once put it, ‘often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies’.