What if we are facing an investment opportunity?

How to benefit from current government intervention for further growth

The Federal Reserve bids farewell to the year with a new interest rate hike, the eighth in 2022. The FED (Federal Reserve) raised interest rates by 0.5 percentage points. Although this increase slows the pace of the trend, analysts predict that it will continue to increase the price of money until it exceeds 5% in 2023. The FED and the ECB argue that in order to control inflation, they must curb consumption by raising interest rates, thus cooling the economy and ultimately bringing prices down, as has historically always worked. 

It is said that when you are in the investment business, you should not only focus on what is described but also need to read between the lines. In this sense, I think there are several relevant readings. There is current pessimism reflected on my screen by red numbers and descending lines that I do not consider as such. What if it is a great opportunity?

Capital Markets Union, Listing Act, and its mission

As we already know, the Capital Markets Union (CMU) aims to ensure that money (understood as investments and savings) flows through the EU to benefit consumers, investors, and businesses. To this end, it designed a plan in 2020 with 16 actions, both legislative and non-legislative, to achieve the three main objectives:

  1. Support a green, digital, inclusive, and resilient economy recovery by making finance more accessible to European companies.
  2. Make the EU a safer place for people to invest in the long term.
  3. Integrate national capital markets into a genuine single market.

On December 7, the European Commission approved the proposal for the regulation of the second action (CMU2), the Listing Act, in order to ensure stability and meet the different financing needs of SMEs and the EU economy in general. It advocates broadening the range of channels through which companies can finance themselves on reasonable terms (demystifying the need for bank debt to sustain business growth).

As a result, companies will be encouraged to go public and remain in the EU capital markets. Easier access to public markets will allow companies to diversify and take better advantage of available sources of financing. 

The proposed amendments focus on the following:

  • Simplifying the documentation required by companies to list on public markets and streamlining the review processes by regulators, thus speeding up and reducing the costs of the listing process.
  • Help companies become more visible to investors, encouraging greater investment attraction, especially for SMEs.
  • Enable companies to list on alternative markets using multiple voting share structures. In this way, they can retain sufficient control of their company after the IPO and protect other shareholders.
  • Simplifying and clarifying market abuse requirements without compromising market integrity.

CMU2 focuses on the above because of the dominance of bank financing versus capital markets financing in the EU, contrary to other geographies. One can see it by comparing venture capital investments in the US versus the EU, as they are ten times higher as a % of GDP.

Equity-based financing can provide a more efficient and appropriate funding source than banks in high-growth sectors that rely heavily on intangible assets, as well as high efficiency in reallocating funds to greener sectors and technologies.

Equity financing provides opportunities for many investors who would otherwise not have access to these opportunities. Since the financial needs of SMEs and startups are not always easy to reach, CMU aims to use capital markets to connect investors with these financing needs, thus facilitating the participation of these emerging companies with great potential for exponential growth and democratizing access to investment opportunities. 

For this purpose, the EU, through the Listing Act, promotes the need to simplify the access rules, listing requirements, and subsequent requirements of the SME financial markets. They are working towards making the markets much more attractive to companies and investors and facilitating the inflow of capital into companies.

Inflation effect and opportunity cost

Inflation refers to the general increase in prices in the economy over a sustained period. Yes, and not so long ago, it was much higher. During the 1970s and 1980s, prices raised by 10% to 15%.

The funny thing is that, in the EU, most households still hold a disproportionately high share of their wealth in bank deposits. According to the ECB and Eurostat, the savings held in European bank deposits increased sharply between 2016 and 2021.

The problem of keeping savings on deposit with a bank in a low-interest rate environment is a loss of purchasing power, as inflation erodes the value of household money year after year. Even though deposits are starting to be more profitable, experts consider it challenging to combat the loss of purchasing power without taking on more risk.

Implementing a long-term perspective in the current scenario is of paramount importance. According to a study based on simulations conducted by EFAMA (European Fund and Asset Management Association), the real value of bank deposits was 24% lower at the end of 2001 and most likely to be 28% lower at the end of 2022. For example, if we had €100 k in a deposit in 2001, its value would be almost €76 k today. This loss of purchasing power occurred in an environment where inflation in the European Union remained under control, averaging 1.8% over the period 2002-2021. The current rise in inflation will further exacerbate the problem.

The European Securities and Markets Authority (ESMA) highlighted that retail investors suffer from a “monetary illusion” as they tend to view their wealth and income in nominal terms rather than recognizing its real, inflation-adjusted value.

So, why don’t we act accordingly? The main reason, I believe, is the fear and lack of knowledge of households on how to interact in these circumstances, as they understand it as assuming a higher risk. We have already experienced this situation at other times in history.

Where can we take the profitability out of inflation?

The real estate sector has always been a refuge for large capitals during periods of high inflation. However, it is true that in the current situation, due to the economic slowdown, we find ourselves in a sector that can suffer. If we properly analyze the current situation, this crisis has nothing to do with the last ones: they were not caused by the demand for credit. The developers do not have excessive debt problems and demand continues to exceed supply in many market niches, opening two windows for real estate investment: direct and indirect investment.

In the case of direct investment or real estate wealth creation, we must consider that the higher the inflation rises, the higher the property values will be. While it is true that variable mortgages will make the effect net, all those who have a fixed mortgage should see their profitability increase.

Indirect investment, made through crowdfunding or crowdlending alternative investment platforms, allows access to investment opportunities that, until now, were only accessible to high net worth or professional investors, turning them into businesses, analyzed and managed by expert professionals, in which annual returns higher than those offered by the traditional market can be obtained.

The history of value stocks indicates that they tend to do better during inflationary periods and are less sensitive than growth stocks.

Commodities. These include gold, raw materials, and other natural resources that are generally critical to production. Simply put, the cost of production meets demand as demand rises, and so do prices.

Public vs. private investment

In the coming years, public investment will grow, boosted, among other measures, by the Recovery, Transformation, and Resilience Plan. This plan constitutes an instrument to channel most of the European funds received under the Next Generation EU (NGEU) plan estimating an expenditure of €83 billion between 2020 and 2026, complementing public investment earmarked for the COVID-19 health crisis.

This scenario would continue the current trend of growth in public investment as a % of GDP, which had been declining sharply since 2008 until the health crisis reversed the trend.

The question to ask at this point is: “Is public investment a substitute or a complement to private investment?” The answer, as stated in the Bank of Spain’s article on the Eurosystem, is: “It depends, it can only be answered through an empirical analysis”. Although several theories support one tendency or the other, we should look at the time horizon of the investments. 

Generally speaking, public investment has a short-term impact. However, there is some consensus that the effect is positive on private investment in the long term if the following assumptions are met:

  • When the contribution of public and private capital is sustained over a long period
  • The greater the dynamizing potential on productivity. Thus, public investment spending increases the return on private capital and, therefore, higher private investment.

Once I connect the dots, there’s no doubt it’s a good time to invest.

On the one hand, the EU is lowering the requirements to encourage investment in companies with potential. However, the regulator has the final say on admission. There is obvious collusion). The cost reduction and the promotion of interesting projects would improve their profitability (reduction of structure costs) and, therefore, the profitability of the investment. 

On the other hand, government interventionism does not seem to have an end. It continued with the health crisis, and we now have the Next Gen funds. There is nothing that makes me think that it will stop injecting capital into start-up companies later on. The EU is trying to generate productive fabric. For this reason, the EU must help the companies with the greatest potential, according to its criteria. All of this, without considering the past quantitative easing, state aid plans, and other measures carried out in the last few years.

The recent interview with Rusell Napier indicated that we would see a boom in capital investment and reindustrialization. The renowned lawyer and investor pointed out that this boom would last about 15-20 years and would probably lead to stagflation: a concept that indicates the moment or economic situation in which, within an inflationary situation, the economy stagnates, and the rate of inflation does not fall). This forecast, besides making a lot of sense, is very likely to happen. Therefore, why not take advantage of this window?

I have previously explained the opportunity cost of holding money in bank deposits, which, in this situation, will only devalue wealth. Also, the benefits of investing to eliminate the inflation risk have been discussed. Thus, the experts’ recipe for softening this blow is definite. You need to put your money to work, i.e., invest in a product with a return that can beat inflation. When investing, look for opportunities in undervalued companies (value stocks) or companies with strong growth potential (startups).

Taking the opportunity, I recall the article “Reasons why you need to diversify when investing in startups” that I wrote a few weeks ago to explain the normal distribution of stocks and the fat-tailed distribution of startups in listed markets. Unlike in listed stocks, the Alpha linearly increases as you increase the portfolio. For this reason, diversifying becomes a critical part of your portfolio.

Blas Simón, CFA
Head of Capital Markets

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