Warren Buffett: How to Invest During High Interest Rates

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So, probably the biggest challenge we as stock market investors face today is that we're investing during a period of higher interest rates. We haven't seen interest rates this high since around 2007. But because of that persistent inflation we've seen from 2021 until now, the Federal Reserve's had no choice but to raise, and that's obviously not great for us investors, because the Fed raises interest rates deliberately to try and slow the economy down. Now, we profit when businesses are doing well, not when they're being deliberately pulled back.

So, what do we do? Well, there's one man who's invested through the high interest rate periods in the early 70s, the start of the 80s, 1989, 2000, and the last time interest rates were as high as they are now, which, as I said, was in 2007. And that man is Warren Buffett. You know, I've heard he's done pretty well for himself, all things considered. So, I want to get really specific in this video and talk about the actual strategies investors can use to invest intelligently in a period where interest rates are still reasonably high.

Interest rates basically are to the value of an asset what gravity is to matter. If I could reduce gravity’s pull by about 80%, I mean, I'd be in the Tokyo Olympics jumping! Warren Buffett has always said that interest rates are the number one macroeconomic factor behind asset valuations, and that's actually because of government bonds. Because the US is the world's number one economy and because they hold the reserve currency status, the return that investors can achieve from US Treasury bills is colloquially called the risk-free rate.

Now, personally, I don't really like that kind of terminology in investing because, as we know, there is always risk. But in the case of US Treasuries, you would need the United States to default in order to not get your return. In finance circles, because the risk is extremely low on these bonds, they become the yardstick to which everything else is measured. You know, if you can get a Treasury bond at 1%, then chances are you're going to put your money elsewhere, whereas Treasury bonds at 10% are a much more attractive proposition.

Now, when the Federal Reserve raises interest rates—something they've been doing since March of 2022—the returns you get from government bonds do rise. If we have a look at the federal funds rate and put that next to, say, the 2-year treasury yield, we can see that when interest rates are higher, bond yields rise. AKA, investors get better returns from buying bonds. This is obviously important to consider when thinking about investing in alternative asset classes such as stocks or maybe a piece of real estate.

You know, if we take ourselves back to 1981, for example, the 10-year US Treasury was paying a yield of about 15%. Now, in that circumstance, if you consider buying a different asset, like a rental property instead, you need to be pretty sure that your investment will give you at least 15% returns every single year for that investment to be even worthwhile. If it doesn't give you that, you'd just be better off holding the low-risk US Treasuries.

And it's the same concept with stocks as well. If the company isn't going to grow very handsomely and keep that up for at least the duration of the bond, then for many investors, it's simply not worth taking the chance. This is Warren Buffett explaining exactly that concept in 1982 or 1983: "When the long government yield got to 15%, a company that was earning 15% on equity was worth no more than book value under those circumstances because you could buy a 30-year strip of bonds and guarantee yourself 15% a year. And a business that earned 12% was a subpar business then. But a business that earns 12% when the government bond is 3%—there, one hell of a business now. And that's why they sell for very fancy prices."

So, there is this direct correlation between asset valuations and the risk-free rate of US Treasuries. And that leads us to discuss what's happening in the modern day. Well, back when the pandemic first started in 2020, interest rates dropped to effectively zero, and you can see that bond yields fell to effectively zero as well. Now, this made stocks the place to be. But now, since inflation has roared, the Federal Reserve's had to raise the federal funds rate to around 5.5%.

As you can see, the current yield for 2-year Treasuries is a respectable 4.5%, vastly superior to the return seen during, say, 2012-2020. And as Warren Buffett was just explaining, because this Treasury bond rate of return is the yardstick by which all other cash-flowing assets are measured, it means that in higher interest rate environments like today, other assets like stocks or real estate don't look quite as enticing as they once did. So, you've had this incredible change in the valuation of everything.

The question is now, well, what do we do? We're in an interesting spot right now. Interest rates are at 5.5%, government bonds are paying decent returns, but you'd still imagine most well-run businesses should be able to return better than that over time. It's this weird middle ground where conditions aren't the best for stocks, but also returns aren't the best for bonds.

So, what do we do in this weird middle ground and how does someone like Warren Buffett approach the problem of where to put his money? Well, this is his philosophy: "If we thought we knew what the dollar was going to do or what interest rates were going to do, we wouldn't do it. But we would engage in transactions involving those commodities, in effect, futures directly. We always try to focus on what's knowable and what's important. What's knowable and important about Coca-Cola is the fact that more and more people are going to consume soft drinks around the world and have been doing so year after year after year. And that Coca-Cola is going to gain share and that the product is extraordinarily inexpensive relative to the pleasure it brings to people."

So, that's the kind of thing we focus on, and interest rates and foreign exchange rates, important as they may be in the short term, really are not going to determine whether we get rich over time. While in the short term, interest rate movements do move the market, in the long run, if you're buying individual businesses, it ultimately will be the fundamental performance of the business that determines the stock's success.

For example, we can hone in on Coca-Cola and look at its performance through the 70s and 80s. During that time, the economy saw wild swings in both inflation and interest rates, yet if you look at Coca-Cola's net income across the 20 years, you get something that looks much more consistent. No matter what was going on in the broader economy, no matter what the Federal Reserve was doing with interest rates, people were still drinking more Coke.

If we look at the share price line over the 20-year period, you can see the stock went from $82 to around $430. While there were some bouncy periods, ultimately, in the long run, the stock price always reflects company performance as opposed to macroeconomic conditions. But to be fair, you could argue that I am cherry-picking a little by using the example of Coca-Cola, a company that in hindsight we all know has done very well.

Because there is the very valid argument that rising interest rates do financially strain a company. For example, rising interest rates puts the clamps on the consumer, which means they have less to spend. Businesses, therefore, make less money. And beyond that, it makes debt servicing more challenging because interest costs will rise as debts get rolled over.

So, when we're looking at companies on a case-by-case basis, as Warren Buffett suggests we do, what specifically can we check for that will help the business cope perfectly fine, no matter what macroeconomic environment it might be exposed to? Well, the first thing to look at is a competitive advantage or a moat. Warren Buffett once said, "In business, I look for economic castles protected by unbreachable moats." And that's because just like how the moat protects the castle from attackers, the company we invested in will be protected from attackers by its competitive advantage.

For example, while Coke performed well back in the time period we described earlier, the underlying reason it did so is because it had an unmatched brand. Even today, the Coca-Cola brand name is enduring, so much so that in blind taste tests, people prefer Pepsi but are more likely to buy Coke. This brand has always protected the company's sales and growth, and it keeps the business as the number one soda to this day.

A brand moat can also be seen in businesses such as Louis Vuitton, Ferrari, or Nike. You know, there are switching moats held by companies like Adobe, Apple, or Microsoft that keep customers locked into a particular ecosystem. There are barrier-to-entry moats held by companies like Boeing or Airbus, Carnival, Royal Caribbean. There's the monopoly moat held by companies like Google in internet search or Luxottica in sunglasses.

So, finding a business with a moat is really critical when interest rates are high. At the end of the day, they are less likely to see a slowdown in revenue due to a weak consumer, and if the moat is strong enough to give them pricing power if times get tough, usually they can still raise prices by some margin to help their business out. So, moats are really the secret sauce to combating the most painful macroeconomic conditions.

But beyond that, one more thing to be particularly mindful of in times of higher interest rates is debt and, more importantly, interest expense. Because a lot of companies simply roll over their debts when they come due, it's important to understand when their various debts are coming due, how the interest rate expense will be affected over time, and also whether they can pay it.

For example, if you look at a business like Google, they had $94 million of interest to pay across the three months ending 31st of March 2024, but they had $23.7 billion of net income coming in and over $24 billion of cash sitting on the sidelines. I mean, interest rates could be anything, it really wouldn't phase Google from that perspective.

Now, look at another business with a moat but one in a very different position: Carnival Cruisers. They had $471 million of interest to pay in the three months ended February 29th, 2024, and they only brought in $276 million total for the quarter. So, after factoring in interest, they lost money for the quarter. In comparison, if we look at the last quarter before the pandemic, their interest expense was just $49 million and they had $423 million in net income.

So, it's interesting to see how that business is now suffering after having taken on huge amounts of debt because of the pandemic and is paying more interest due to higher rates today. Granted, they only had $518 million in cash on the books in 2019 versus the $2.2 billion now, but you can still definitely see the impact of higher debt and rising interest rates by their interest expense in 2024.

So, as Warren says, it's important to focus in on the individual business as opposed to the broader macroeconomic landscape. In my opinion, checking for moats and also watching the debt management of a company can be really helpful, specifically in times where interest rates are higher.

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The best time to buy stocks in recent years, you know, has been when interest rates were sky-high, and it looked like a very safe thing to do to put your money into Treasury bills. With port, actually, the prime rate got up to 21.5%. But you could put your money out at huge rates in the early 80s. As attractive as that appeared, it was exactly the wrong thing to be doing. It was better to be buying equities at that time, because when interest rates change, their values change even much more.

And that is a really important thing to remember: when interest rates do eventually come down, that is a really good sign for the stock market. So, even though some of the companies—granted, not the magnificent seven—but some companies in the market are a bit beat up, as long as they're sound businesses, then buying during higher interest rates at depressed valuations can definitely be an advantage when the shackles get lifted and rates are lowered. Remember, when the risk-free rate falls, it makes stocks look even juicier, and money tends to flood in.

But overall, guys, I hope that was an interesting look into investing during higher interest rates. Please leave a like on the video if you did enjoy it, and with that said, I'll see you guys in the next video! [Music] [Music]