In a recent interview on CNBC, Warren Buffett mentioned that if interest rates were to stay below 3% on the 10-year, stocks are incredibly cheap. I talked about the same thing in the recent podcast with Tobias Carlisle. The reason that this is so, is because interest rates have an almost gravitational impact on stocks. The higher the rates, the lower the valuations, as the opportunity cost of owning stocks is higher.
As investors, we are providing real cash now, for the prospect of investment growth at a rate higher than we could get in something like Treasury bonds. If an investment that we make grows at 10% per annum, in about seven years, we will have doubled our money. However, with rates as low as they are currently, even if we just returned 5% per annum, that would significantly outpace the 10-year Treasury, which is only yielding 2.5%. If interest rates were 10%, then even a 9% return would be undesirable.
No investment is risk-free. We must always put an adjective before risk, as the the risks we try to avoid are the risks of permanent losses of capital. U.S. Government bonds biggest risks are likely interest rate and inflation risks, which would most likely go hand in hand. If you are buying the 10-year bond at a 2.5% yield, and inflation is 2%, your real return is only .5% per annum. If inflation is 4% per annum, then your are actually losing 1.5% each year in real money. A 1% increase in the Federal Funds rate, typically results in roughly a 7% decline in the 10-year Treasury bond due its relatively long duration.
The best way to measure the intrinsic values of equities is through the discounted future cash flows that the company will produce in perpetuity. The estimates of intrinsic value are only as good as the inputs, so valuing securities is often more of an art than a science. Because of the imprecise nature of these calculations, we must require a very large margin of safety before we make an investment. This means that if our estimates are overly conservative, we should generally still be okay and not lose money. Obviously, that isn’t always the case, but this is a framework that has increased our probabilities of success.
In my opinion, the best way to compare stocks and bonds is through looking at the earnings or free cash flow yields, versus the implied interest rates on various bonds. Usually free cash flow is a better metric to use, as it is the true measure of the amount of money that is available to shareholders’. For companies such as financials, earnings are a better proxy, just due to the nature of how the accounting works.
The earnings yield is simply the inverse of the price to earnings ratio. If we are buying a stock at 10 times earnings, that implies an earnings yield of 10% (1/10). If the company was going to pay out 100% of its earnings as a dividend to investors, the dividend yield would be 10%. Most companies don’t do this of course, as they choose to reinvest most or part of their earnings into growing the enterprise, and/or they supplement the dividend with stock buybacks. Stocks are generally more volatile than bonds, so they should usually require a higher earnings yield than something like a 10-year Treasury bond.
At T&T Capital Management, many of our current investments trade at less than 10 times earnings. We don’t necessarily seek out low P/E or P/FCF stocks, because often that means less implied growth, but value stocks are extremely undervalued relative to growth, so that is where we have been finding the best bargains. Most of these companies have clear paths to long-term earnings growth, while also providing for an adequate margin of safety for a weaker than expected economy.
We would be happy to pay 20 times earnings, if the company were likely to grow its earnings per share by 15-20% per annum, but historically high growth rates tend to mean-revert over the long-term, so one must be careful paying up for future expectations. The consequences for paying too much for great companies have been shown on many occasions, most notably during the 2000 tech crash. Fantastic companies such as Microsoft, Intel, and Cisco, became terrible investments due to the prices being paid. One must wonder if we are seeing similar levels of speculation in today’s environment.
By investing in undervalued companies that should be able to continue to grow earnings, even if the economy gets a bit more challenging, we are creating an attractive portfolio, with strong future prospects. This is a uniquely constructed portfolio compared to something like the S&P 500 index. Indexes buy more of what has gone up, irrespective of any valuation metrics or business prospects. We keep reiterating that to continue to provide strong performance over the next 10-years, we have to invest differently than the overall market. Interest rates can’t continue dropping like they have over the last 20-years, so valuations for the overall market are more likely to contract in my opinion. If we are wrong, we should still do well and make money as stock climb, but if we are right, than we should be significantly better off than had we not accounted for these risks.
One compliment we get from clients is that after their accounts have gone up so much, they sometimes ask me at what time they should take profits and convert to something like bonds. In an actively managed account like all of ours are, we are doing this on a regular basis. When a stock gets fairly valued and we have better investment opportunities, we sell it and buy the more attractive option. If the best priced security is a bond, we are willing to buy aggressively. We are agnostic as to what type of security we employ, whether they are stocks, bonds, options, etc.
In addition, because we are managing separately managed accounts (SMAs), as opposed to a fund, each portfolio is hand-crafted for the individual. This means that the allocation might and usually should differ, for a 40 year-old at the peak of their career, and an 80 year-old retiree. Another advantage to separately managed accounts versus funds, are that when the market is tanking, you can hold on to your positions and buy more. Often mutual funds and index funds face massive redemptions, which forces them to sell stocks to meet the fund flows. If other clients were to panic with an SMA, it has no impact on your portfolio, which is a huge positive.