On Wednesday the Federal Reserve raised interest rates by 50 bps, or 1/2%. Initially the market reacted favorably to this with a strong rally on Wednesday, only to be reversed with the biggest down day since 2020 on Thursday. Tech/glamour stocks have simply been getting obliterated. Tesla dropped 8.3% on the day, while Amazon dropped by 7.6%. Both are outstanding businesses but the prices paid do matter, which was something many market participants forgot about the last few years. Value stocks have been outperforming, but on down days like this everything is going to be down, just fortunately less than the market. What’s important to realize is what higher interest rates mean for various companies. For stocks such as Tesla and Amazon, it almost certainly means a lower valuation multiple as the opportunity costs have increased materially. For stocks such as a Bank of America, or AIG, they should make materially more money with higher interest rates.
AIG reported an absolutely fabulous quarter, with the stock rising dramatically after results were released. The company has totally revamped its insurance underwriting operations, and is now generating massive underwriting profits. Higher interest rates are allowing the company to invest its insurance premiums into higher yielding assets, leading to higher investment income and profits. These factors combined with a stock trading at a material discount to book value, give us a very large margin of safety and substantial upside. AGO reported results after the close today, which were very impressive with most book value per share metrics reaching all-time highs once again. Below investment grade exposure in the insured portfolio is the lowest ever, which has the company in its strongest financial position in history. The stock trades at around 43% of its adjusted book value per share, so we once again have tremendous upside and a large margin of safety. Both AIG and AGO are aggressively buying back stock. These companies have performed very well for us even in this terrible stock market.
The biggest beneficiaries of the interest rate hikes will be the banks. They have many billions in liquid excess capital, which can now be reinvested at substantially higher rates. Net interest income will go up by billions for the big money center banks such as Bank of America, Citigroup, J.P. Morgan etc. Credit quality is very strong and the companies are already reserved for a recession. The dividends are solid and the valuations reflect extreme pessimism. Barring a nuclear detonation or a full-fledged WW3, I think we could see huge rallies in several of these names. Citigroup could rally by 50% and it would still be cheap to put it into perspective.
We’ve also had core positions in pipeline companies such as Enterprise Product Partners and Kinder Morgan. These stocks pay huge dividends, are vital to our infrastructure and energy resilience, and are benefiting from the surge in energy prices. This Tech selloff has allowed us to sell puts on high quality companies such as Facebook, Netflix, and Roblox at levels that once seemed unthinkable. Many of these options will expire worthless, generating attractive returns for us, while some might be exercised allowing us to own these companies at 70-90% discounts from their all-time highs. These companies have a great combination of earnings growth, cash flow, and strong balance sheets. The same people that bought Facebook at $350 are often selling at $180. We take the opposite approach. It’s been the worst start to the year in history for equity and bond markets. Trillions have been lost in both. Even something as mundane as investment grade bonds is down 13% on the year. This wipes away several years of interest payments on such low-yielding securities.
I believe our strategy is solid for this environment. Value stocks are holding up better and should continue to outperform. To get the full value of the options, we need to wait for expiration, which for most is in late January. At that point in time, volatility and time value go to zero, and the only thing that matters is where the stock prices are at relative to our strike prices. These alternative strategies provide us with a major advantage versus many of our peers that have only been able to play with stocks, bonds, and maybe some real estate funds, or annuities. We are planting the seeds that eventually should lead to a robust harvest, but we’ve got to get through these dreary and frankly dangerous times, with how things are escalating in Europe. We will keep you posted as things develop as always.