For months, as the Federal Reserve has been raising rates in an effort to slow inflation, we’ve been waiting for something to break. That’s because we have learned that whenever the Federal Reserve pushes short-term rates above 2-Year Treasury yields—as is the case today—something bad generally happens in the economy.
Well, in the first quarter, that turned out to be the banking crisis. After the sudden collapse of Silicon Valley Bank, Signature Bank, and Silvergate Capital in March, along with worrisome headlines swirling around Credit Suisse and First Republic, investors were left scrambling to figure out which institutions needed to raise capital quickly to shore up their balance sheets.
As disciplined value investors, we view this as a positive development. Heading into the quarter, there had been indications that fundamental factors such as valuations and earnings were finally being taken seriously again. However, investors hadn’t completely bought in, as they continued to overlook balance sheets in general and leverage specifically. That’s likely to change now, thanks to troubles in the banking sector which in turn have driven up credit spreads.
To be sure, in past crises, the Federal Reserve has raced to the market’s rescue by printing money, which in turn has resuscitated speculation. Complicating matters for the Federal Reserve this time, however, is that inflation remains a front-burner concern, as is the growing federal budget deficit, sovereign debt, and corporate and consumer leverage.
In this environment, balance sheet strength is paramount, especially in the small-cap space as the screws are tightening from a funding perspective. Credit stress typically shows up as the Federal Reserve raises rates, as can be seen by the performance of leveraged loans relative to the Federal Funds rate in the chart below.
Source: Bloomberg L.P., Standard & Poor’s, monthly data from 1/31/2010 to 3/31/2023. The chart represents Federal Funds Rate Index compared to Leveraged Loan Pricing. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
At the start of the year, it was challenging enough for smaller companies to raise capital in the fixed income and equity markets. Now the banking market is starting to close. This shines a spotlight on financially sound, well-run businesses with sound strategies, which are traits embedded in our 10 Principles of Value Investing™.
Indeed, in this environment, the types of companies we have always focused on — well-managed companies with little or no leverage, strong balance sheets and consistent free cash flow generation to self-finance their organic growth and raise their dividends over time — stand to benefit going forward.