The Low Interest Rates And The Value Investor – An S&P 500 Story
by Anton F. Balint
Never before has the interest rate environment been so unusual, uncertain and aggressive for company valuation and capital allocation. The debt issued by the United States, in the form of Treasuries, has been for decades considered one of the safest assets for investors to hold. For example, the interest rate on the 10 year US Treasuries has been set as a risk free rate of return by many value investors, such as Warren Buffett (The Warren Buffett Way (2013) by Robert G. Hagstrom) and Joel Greenblatt (The Little Book That Beats the Market (2010) by Joel Greenblatt). Presumably, the price of a stock ought to be measured against the return an investor will get from it when compared to the return from a risk free investment (such as the 10 year US Gilt). Therefore, at least in theory interest rates play a crucial role for valuating stocks. However, for the past 10 years the financial world, especially long-term investors have been facing a unique challenge: to find the intrinsic value of a corporation in a low (very low) interest rate environment that at some points went into negative territory.
In a moment I will look at whether the low interest rates have a massive impact on the most followed stock exchange – the S&P 500, a benchmark that is considered by many analysts, investment professionals and finance journalists as an indicator of how confident investors are in the US economy. However, firstly we must understand what interest rates are and how they operate.
The Money Supply Machine
The Federal Reserve, the Central Bank of the United States, has as one of its responsibilities to set the monetary policy, i.e. to control the supply of money. It does so by raising or lowering interest rates: when interest rates rise, the supply of money is curtained and when they are lowered, the money supply is growing. More importantly, according to Siddhartha Jha (Interest Rates Markets: A Practical Approach to Fixed Income (2011), Chapter 3), the movement of interest rates, and therefore, the fluctuation of money on the market ought to be an inflation responsive process: when there is a threat of rising inflation, the interest rates should be raised. Consequently, when deflation is on the horizon, the money supply should be expanded to encourage consumer spending and credit creation. Therefore, the first point to realize is that the Federal Reserve’s monetary policy has as end goal to strike a balance between economic growth and changes in prices.
From a mathematical perspective, the relationship between interest rates and companies’ prices is as follows: Expected return on stocks (r) = Interest rate on risk free investment (in our case the 10 year US Gilt) + Risk Premium (the premium an investor expects to get for investing in riskier assets than the 10 year US Government bond). If the risk free rate drops, naturally you are left with risk premiums and the equation will naturally give a positive, resulting that value grows when interest rates drop. However, according to Aswath Damodaran (Dealing with low interest rates: investing and Corporate Finance Lessons, April 2015) this is a simplistic view because interest rates do not operate in a vacuum. It is true that they are the result of supply and demand of borrowing, as Siddhartha Jha explains in Chapter 6 of his book, Interest Rates Markets: A practical Approach to Fixed Income (2011); nevertheless, economic news, financial turmoil, political crisis and technologies all impact on economic growth and therefore, influence the supply of money.
Therefore, the questions that we must answer are: how is the current interest rate environment impact on us, value investors, and how do we deal with it?
Low interest rates' impact on stock valuation
If we follow the mathematical formula from above it is clear that we get a result with over-valued companies in a low interest rate environment. However, is this really true? Whilst money supply is an important factor in establishing the value of a return we might get from out investments, it is not the only one. If an investor simply looks at the S&P 500 and sees that the index grew from 571 on 14 October 2005 to 1.132 on 8 October 2015, with a 10 year peak value in late August 2015 (1.192), and then looks at the rate for the 10 year real Treasuries (that is after inflation was taken out of our consideration) he will observe that the index almost doubled whilst the rate went down from 2% to 0.5% for the same period. A quick and yet childish decision will be to correlate the two pieces of information and conclude that the money supply reflects economic growth and that the stock market must be in a bullish (over valued) state. This might be true.
However, as mentioned above, the interest rates must be put into perspective and considered as one piece of the puzzle when looking for the intrinsic value of a company. Philip A. Fisher, in his master piece book, Common Stocks and Uncommon Profits, suggest a wide range of qualitative considerations that an investor must make when assessing the price of a company. They range from management’s ability to earn a high return on the investment earnings, the client base and market share to your age and financial goals. Of course, this interest rate environment is unusual and yes, it is difficult to price companies right but it is not supposed to be easy if you want superior returns. As legendary value investor and Chairman of Oaktree Capital, Howard Marks, explains in his September 2015 memo, superior return is the result of superior judgment and implementation. In other words, you must see interest rates as part of a bigger picture and not the sole influencer of your portfolio.
What can value investors do?
Firstly, the must accept that the old way of relating to the risk free rate might never come back and the value of a business must be assessed solely on its merits, both qualitative and quantitative.
Secondly, they can use this abnormal situation to profit from it. Over the past 3 years, almost every day we see the financial press, such as the Financial Times, presenting how investors (mostly short-term speculators) panicked because the Federal Reserve might or might not move the rates. This created volatility that reduced the prices on many companies. Remember what Benjamin Graham said: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Thirdly, as Joel Greenblatt suggests, if you are an experienced investor, you might feel that you were comfortable in the past with a specific risk free rate and set your valuation against that. For example, Mr. Greenblatt suggests 6%.
Finally, look at others metrics that show how the company is performing in the current monetary and economic environments: enterprise value to operating earnings, steady cash flows, the dividend policy, its earning power and very important: the historical mean. Compare the prices of your options today with what they were priced during the 2007-2009 financial storm. Look for clues that will indicate the real return of your investments.
