Westwood says: “Rates have been low for a very long time but last year provided us with a good opportunity to see how the funds react during stressful periods. As expected, many were volatile but frankly, some volatility should be expected as businesses can develop rapidly.”
Clare Pleydell-Bouverie, a deputy fund manager within the global innovation team at Liontrust says, despite innovative companies’ valuations being hit last year as they adjusted to the increase in rates, with rate hikes now potentially coming closer to an end, innovative companies’ stocks are winning again and she expects them “to win in the years ahead no matter if rates stay high”.
“This is because a persistently higher level of interest rates simply means that the qualities of truly innovative companies – the ability to grow strongly and drive high returns on invested capital – become even more important,” Pleydell-Bouverie adds.
“The problems sit with the capital intensive zombie companies on the wrong side of innovation who can no longer pile on debt to stay in the race.”
A capital intensive compny is one which constantly requires new funding, in a higher rates environment this funding becomes harder to obtain. Many market participants take the view that a zombie company is one which has been able to survive due to low debt repayment costs in recent years, but doesn't really generate any profit. In a higher rates world, such companies may not be able to repay their debts.
Likewise, Hyett notes that in a rising interest rate environment profits in the distant future are given a lower valuation today and so it is harder for young companies to raise capital - hitting the value of innovation focussed investments in the short term, with unprofitable and capital-hungry companies hit hardest.
He adds: “Funds investing in more established, revenue-generating and ideally profitable businesses are better placed when rates are rising.
“As company valuations fall in the start-up and venture space, this results in stronger returns over the longer term for investors willing and able to ride out short term volatility.”
Valuation discipline?
So, how should investors think about valuations when investing in innovative companies?
The primary valuation tool used by Franklin Templton is a multi-scenario, multi-year discounted cash flow model, which Curtis says is useful because “it demands they think about the long-term potential of the business in a normalized cost of capital environment”.
He adds: “While we do look at near-term valuation multiples as we seek to understand overall market sentiment, we believe near-term multiples are inapt in evaluating the intrinsic value of a growing and investing business in rapidly changing cost of capital environment.
