In response to some recent world events, I deemed it appropriate to include a few thoughts on the world economy as it stands today. I also deemed it appropriate to follow in the footsteps of Kai Ryssdal from the NPR show “Marketplace,” who opened a recent episode by quoting Charles Dickens in The Tales of Two Cities:
It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.
In the past few days, the world economy has seen two new market records set: record low yields in government bonds markets and record highs in US equity markets. The latter is the most disturbing to me because those record low yields are increasingly negative. But I would like to address the low yields record first.
Record Low Yields
When I went to school, we learned in economics that zero is the absolute minimum interest rate possible. Today, more than half of all outstanding government debt, roughly $13 trillion, carries a negative yield (source: WSJ, BoA Merrill Lynch). In addition, more than 80% of German and Japanese government bonds carry negative yields, while Swiss bonds carry negative yields up to maturity of fifty (50) years! That is outstanding and completely unprecedented.
CHART: Government Bond Yields. (Source: Quartz)
The activity of central banks around the world continues to fuel this situation in the hopes that investors will move into riskier assets and invest in the real economy. It’s debatable whether any part of that strategy has actually worked, at least beyond a certain point. The continuation of this situation has several wide-reaching implications. The most obvious one is that once – not if – interest rates go up, the holders of these bonds will suffer massive losses. To see just how much, I invite you to check out a useful tool that The Wall Street Journal created to calculate the effect of interest rate moves on certain bonds http://graphics.wsj.com/government-bond-duration-calculator/.
CHART: Negative vs Positive Bond Yields. (Source: WSJ)
Even in the very unlikely case that interest rates do not rise sharply and quickly, inflation eventually will, and that will inevitably eat away at the low to negative returns of those bonds. The majority of these bonds are sold to pension plans, insurance companies, and other institutional investors whose obligations are already severally underfunded due to so many years of very low-interest rates. In response, some have moved into riskier and longer bonds in search of yield, which, as the following chart shows, pushes those yields lower. However, most investors have continued to buy with undiminished enthusiasm.
Unfortunately, the wishes of the central banks collided with regulations and institutional incentives, thus forcing institutional investors to exhibit the kind of irrational behavior I described above. In short, I’m afraid this will not end well for anyone holding government bonds, and it could very well have a domino effect elsewhere.
The second implication is that, given the sheer size of the global government bond market, these developments have caused negative rates to spread into other areas. There is already EUR250 billion of corporate debt yielding negative yields (source: WSJ) and many global custodian banks now charge institutions for cash deposits. Remember the days when the bank paid you to keep your money with them?!
Finance Theory tells us to use a weighted average cost of capital (“WACC”) rate to discount future cash flows when calculating the value of investments. So, we can calculate an appropriate WACC by adding a “risk premium” to the so-called risk-free rate. Historically, a “risk-free rate” has usually meant long-dated government bonds. For example, in 1996, 10-year US Treasury bonds yielded 6.76%. This means that a project with a risk premium of 4% would have its cash flows discounted at 10.76%. Such a project would have been considered a successful investment as long as it returned a minimum of 10.76% per annum.
Ten years later, the project would be successful at the then lower threshold of 9.10% (5.10% + 4%). Today, the project would be funded at 5.49%. In the span of twenty years, the required rate of return has almost halved! While it’s true that this has in part been driven by lower inflation rates (3.0% in 1996 vs 1.1% in 2016),I would point out that the absolute level of rates also matters because of the inherent inaccuracy of WACC calculations, especially in extreme cases.
Take, for example, the case of a hypothetical low-risk 10-year project in Switzerland being considered today. It would have a WACC calculation that adds a risk premium to a risk-free rate of negative 0.66%. Now imagine a “low risk” project with a 1% risk premium; it would be funded if it only returned 0.34% per year! In this situation, a calculation error of just a fraction of a percent would have a massive impact on the value of investments and the project funding decision. It can be scary to think that investors and corporate managers have to get to that degree of accuracy when making decisions. As a result, in the “Bizzaro World” of negative yields, so-called conservative investors increasingly find themselves driving down roads with speed limit sign in basis-points.
However, there is an opposing view that states that a combination of deflation risk and capital loss risk in other assets make negative bonds reasonable alternatives in the short-term. While I personally do not subscribe to that view, I acknowledge that the lack of precedent means that we simply do not know how this will end. Neither the full force of my economic logic nor history can provide a fool-proof roadmap into the future.
However, history does teach us is that people will continue to brush their teeth, shampoo their hair, wash their clothes, watch TV, drink coffee, go online, live in houses, and buy jewelry for their loved ones. History also teaches us that in times of financial stress, high quality companies with strong balance sheets and cash flows actually benefit as their weaker competitors fall away or become subject to acquisitions. My colleague Aubrey Brocklebank touches on this point again in his section on cyclical assessments later in the report. In helping to polish our investment process, Aubrey has coined the term “Occam’s Investment,” which states that “the investment reliant on the least number of assumptions is likely to be best.”
We believe that in an environment with bonds at very risky levels, cash carrying a high risk of loss of purchasing power, and real estate paying low yields (and capital gains on it unlikely), owning high-quality companies purchased at reasonable prices will prove to be the best strategy to secure your capital. In our current environment, equities might, in fact, be the least risky asset.
Record High Equity Markets
This leads to the other record achieved this week, a new high in the Standard and Poor’s 500 Index. News organizations around the world reported that, despite a little tantrum following the UK’s “Brexit” vote, US equity markets “roared” back to new record highs. But be careful: hearing the word “roared” may lead you to overestimate the index’s performance. The fact is, despite high volatility over the past two years, the S&P is only marginally above its position in late 2014.
A strengthening economic recovery has barely registered in equity investors’ minds, especially because of the profit drag from a stronger US Dollar. What’s more, a slow withdraw of monetary stimulus by the Federal Reserve has kept a tight lid on stock prices.
From a valuation perspective, there are three equally valid conclusions, in my opinion. On the negative side, and despite the index level barely rising, the US market looks more expensive today than it did two years ago. This is due to primarily to depressed corporate earnings, which have been hurt by a strengthening US Dollar, and which in turn makes international revenues (roughly 40% of total) translate into fewer US dollars. The Shiller Cyclically-Adjusted Price-Earnings ratio (CAPE) shows a CAPE in the upper 20s, pointing us to the same conclusion. On the neutral side, a look at expected returns on US stocks (as calculated by NYU’s Aswath Damodaran) shows that expected returns on equities are fairly stagnant at about 8% per annum.
CHART: Implied Equity Risk Premium and Risk-Free Rates (Source: Damodaran)
This leads us to the third conclusion and ties in with the issue of low and negative rates. If low and negative rates continue for a very long time—i.e. bond markets are not being crazy—then US stocks look very cheap today, as the spread between equity yields and bonds yields are near an all-time high. Take a look at the chart below, also from Aswath Damodaran.
CHART: Implied Equity Risk Premium for US Equity Market (Source: Damodaran)
The story looks different elsewhere in the world, however. While low rates have arguably had a very positive effect on equity prices in the United States, that effect has not been universal. The S&P 500 is up 74% over the past ten years and has tripled since its 2009 bottom. On the other hand, the MSCI EAFE Index, which measures developed equity markets excluding the US, is up 80% since its 2009 bottom. That being said, it is still below where it was ten years ago and is 30% below its 2007 peak.
When you dig deeper into the country and industry levels, the picture reveals still greater contrast. This outcome has produced a situation where good investment opportunities are scarce; that doesn’t mean they are non-existent, but that only those who are willing to roll up their sleeves and do some old-fashioned stock picking are likely to find them.
Over the past two years, we’ve shifted a significant percentage of our portfolio from the US and into European stocks. We did not make this decision on a top-down basis, but rather the shift occurred organically as we have focused on finding value. Based on where we are finding opportunities today, I expect that trend will continue. I also expect a continuation of high volatility, which I believe plays into our strengths and gives our strategy the chance to shine.
Because we view ourselves as owners of the companies we have in our portfolio, we like to keep an eye on the “look-through” results of the companies we own. The current free cash flow yield on our portfolio companies is around 7% per annum; this is the cash that those business can pay us after covering all expenses, including all required investment to maintain and expand the business. In other words, for those willing, like us, to look beyond the short-term fluctuations in market prices, 7% is the current economic “yield” we are making by investing in these businesses. But unlike a bond, this yield will grow in the future. That, on top of a 7% yield, should ensure that our portfolio does very well over the long run. Also, we do not believe we need to make many assumptions here to get a moderate to low growth rate. All we need is for teeth to be brushed, hair shampooed, television watched, clothes washed, coffee brewed, websites browsed, houses inhabited, and diamonds to remain a girl’s best friend.
We took advantage of market volatility at several points during the quarter to add to our existing investments in Richemont, Swatch Group, Linde, Nordstrom, Express Scripts, and Unilever. To enable these purchases, we sold our investments in Nestle and Coca-Cola and reduced our investments in Medtronic, Kering, and Mattel.
We also initiated two investments during the quarter. The first was in the preferred shares of Samsung Electronics. Samsung Electronics manufactures a range of consumer and industrial electronic goods and holds a leading position in memory, mobile handsets, displays, and other consumer electronic devices. While the company’s business moat is not as strong as our other holdings, we believe that Samsung’s common shares trade at a very big discount to intrinsic value, while the preferred shares trade at an even greater discount. The investment also exhibits some positive “optionality” in that there are several potential positive developments that could materialize in the future, any of which would create a lot of value to us.
The other investment we initiated this quarter was in a basket of U.K. homebuilders, which we purchased shortly after the United Kingdom voted to leave the European Union. We believe the market overreacted to the downside on U.K. homebuilders, and we purchased them at a significant discount to a very conservatively-estimated intrinsic value. This investment will likely be volatile in the short term, but the potential upside is extremely significant and the downside quite limited.
This post has been excerpted from the Mayar Fund June 2016 Letter.
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