The Broyhill Asset Managment Letter for the month of August 2016 on “What Happens When Interest Rates Fall Below Zero.”

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If I had a world of my own, everything would be nonsense. Nothing would be what it is, because everything would be what it isn’t.” – Alice’s Adventures in Wonderland, Lewis Carroll

August 16, 2016

In A Short History of Financial Euphoria, John Kenneth Galbraith speculated that financial memory should last a maximum of twenty years. “This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”

Twenty years is a long time. It is a particularly long time for the attention span of today’s investors who are challenged to hold onto investments from quarter to quarter. So perhaps it should not come as a surprise that we have already experienced two financial disasters in the past twenty years. And already, a new generation of investors has entered the scene. The “innovative genius” of zero percent interest rates has allowed economic amnesia to set in quicker than ever. Financial disaster has been erased from financial memories. In its place is a parallel universe where zero interest rates justify any price. Weird stuff happens when interest rates fall below zero. Investing is about to get weird.

In a zero interest rate world, everything is nonsense. But nonsense interest rates do not change the fundamental truth of investing – the value of any asset is still determined by its future cash flows. The following example may help to illustrate this dynamic.

If we break down the value of a firm into two components – steady state value and future value creation – we can isolate the impact of interest rates on stock prices. The steady-state value of a firm is the value of a business assuming that it maintains a normalized level of profit into perpetuity. It can be derived by the perpetuity method, dividing the firm’s current net operating profit after tax (NOPAT) by its weighted average cost of capital (WACC).1

We can also use this formula to derive a steady-state price-earnings multiple, which is the reciprocal of the cost of equity. For example, an 8% cost of equity translates into a steady-state price-earnings multiple of 12.5 times (1 / .08 = 12.5). We’ve labeled this column Normal on the chart below. Moving from left to right, you can see the impact of lower interest rates on steady-state price-to-earnings multiples.

Interest Rates, Broyhill Asset Management, Credit Lending

In looking at this chart, one might conclude that stocks “deserve” to trade at 25x earnings in the current interest rate environment. One might also surmise that fundamentals don’t matter at zero interest rates because any valuation can be justified. Or that traditional tools used to value securities no longer work in such an environment. Perhaps stocks really have reached a permanently higher plateau.2 If you find yourself listening to someone making these arguments today, we suggest you run as fast as you can in the other direction. This is not Cheshire Cat’s reality.

A Relic of the Past

The chart below is an illustration of the world we used to live in. Stocks have compounded at 11% annually since 1950. Bonds advanced 6% per year. Take a close look because you are unlikely to see these numbers again anytime soon. These returns are simply not on offer today.

Interest Rates, Broyhill Asset Management, Credit Lending

A recent paper by McKinsey titled Why Investors May Need to Lower Their Sights concludes, “The forces that have driven exceptional investment returns over the past 30 years are weakening, and even reversing. It may be time for investors to lower their expectations.”

The author’s “detailed analytical framework” suggests that stock and bond returns could be considerably lower over the next two decades. The summary is worth a read but we think sixty pages of detail still missed the mark. Investors only need to consider a few key points to reach a similar conclusion.

Real returns on equities have averaged 6.5% over time. McKinsey forecasts 4.0% – 6.5% real returns going forward. That’s probably best case. The base case is likely lower due to four factors:

  • The population is aging and productivity is declining. As a result, trend growth has slowed.
  • It is impossible for interest rates to decline as much as they have over the past few decades.
  • Profit margins are near all-time highs. It is not impossible for them to go higher. It’s just not a high probability outcome. Margins are the most powerful mean reverting force in finance.
  • And valuations are hovering in bubble territory. Again, not impossible for expensive stocks to get ridiculously expensive, but not great odds either.

Expected returns on all components of a conventional asset mix (stocks, bonds, and cash) are now as low as they have ever been. The chart below shows ten-year expected returns (blue line) on a conventional asset mix, along with actual subsequent returns (red line). If the glove fits . . .

Interest Rates, Broyhill Asset Management, Credit Lending

There are two points of interest on this chart. The first is the spike higher in the blue line in 2008-2009. During the financial crisis, expected returns on a traditional portfolio reached 8% as asset prices collapsed. Those brave enough to put capital to work during the crisis have been rewarded.

The second point of interest is in the lower right corner. The most recent data point suggests that investors should not be surprised by forward returns closer to 2% over the next decade. Those daring enough to put capital to work today will likely be punished.

Rolling the Dice

The market doesn’t always generate the returns reported by historical averages. Average rarely happens. And the market won’t give you 6% – 8% just because you need it.

Even in today’s nonsense interest rate environment, two plus two still equals four. Central banks can’t change that math. Yields on bonds are near zero today. Expected returns on stocks are not much better. You can arrange those numbers any way you’d like, but you won’t get them to add up to the 6% – 8% returns investors have grown accustomed to.

This is the challenge all investors face today. There are a few potential responses:

  1. The majority will do nothing. They will close their eyes and hope the market provides the returns they need. They cannot afford to be wrong. They likely will be.
  2. Conservative investors will make the difficult but necessary adjustments to protect their wealth. The most effective way to accomplish this is the most un-American: save more; spend less.
  3. Rather than face reality and tighten their belts in expectation of lower future returns, many investors have found a more acceptable solution.

The third option was outlined for investors in a recently WSJ article which explained why many pension funds are taking more risk to achieve the same required return.3 This is by far the most dangerous response to the current market environment.

Interest Rates, Broyhill Asset Management, Credit Lending

Too many investors are stretching too far for returns. One thing we’ve noticed with age, is that when you stretch too far, you increase the risk that something breaks.

Everybody Has One

Investors are an opinionated group. Despite repeated evidence that most of those opinions turn out to be wrong, being wrong has little impact on self-confidence. This can be a problem. Overconfidence can be beneficial to self-esteem but is likely to be disastrous to performance.

Successful investing is a delicate balancing act honed over years of training. It requires enough confidence to hold onto positions when every bone in your body suggests you are wrong. And it requires the humility to recognize when you are wrong.

We live in a constant state of doubt and have no problem admitting it. Doubt keeps us safe.

And some of the best minds in history have expressed a similar philosophy:

“You see, one thing is, I can live with doubt and uncertainty and not knowing. I think it’s much more interesting to live not knowing than to have answers which might be wrong. I have approximate answers and possible beliefs and different degrees of certainty about different things, but I’m not absolutely sure of anything and there are many things I don’t know anything about . . . I might think about it a little bit and if I can’t figure it out, then I go on to something else, but I don’t have to know an answer, I don’t feel frightened by not knowing things, by being lost in a mysterious universe without having any purpose, which is the way it really is so far as I can tell. It doesn’t frighten me.” — Richard P. Feynman, The Pleasure of Finding Things Out

We have no idea what lies on the other side of today’s extreme monetary policy. We don’t know how markets will react to geopolitical events in the short-term or how they will perform in the long-term. We are aware that most investors prefer an “expert” prediction to an admission of ignorance. There are several investment institutions in the business of providing investors with bold predictions. These institutions and their bold predictions have one thing in common – they are designed to increase brokerage commissions.

Lucky for us, and our investors, we are not in the predictions-making business. Our business is designed to do well when our clients do well. Forecasting the future is not a prerequisite for successful value investing. Rather we can increase the odds of our success by training ourselves to think probabilistically.

To make better decisions, we force ourselves to consider various futures. We work hard to hold multiple contradicting scenarios in our minds simultaneously. We examine past decisions, not to differentiate right from wrong, but to evaluate and improve the process that led to those results.

A Proxy for What Lies Ahead

A lack of forecasting does not imply a lack of preparation. Preparation requires that we consider multiple paths leading to multiple outcomes. We think the most likely outcome for markets will be characterized by low returns and high volatility. This may prove too pessimistic. But if we are wrong, we will be pleasantly surprised (as will our investors) rather than dangerously overextended. Consequently, prudent investors (including our own) should adjust their expectations accordingly.

The first half of 2016 may be a good proxy for setting those expectations. Global equity markets gained about 2% through June but that meager return masked the greatest volatility we’ve seen in years. Our returns were roughly in line with equity markets during the first half with substantially less downside volatility.4 While we are happy with positive performance to date, we place no emphasis on short-term returns and neither should you. Over a longer horizon we would expect our returns to look materially different from the market as our portfolio looks materially different.

As of quarter-end, three of our five largest holdings were not represented in the S&P 500. Together, these five positions represented roughly 40% of our equity portfolio. Our portfolio companies rarely change from quarter to quarter or year to year, as changes in value are far less frequent than changes in price. That said, you shouldn’t be surprised to see more transactions in your portfolio during bouts of volatility. Needless to say, we’ve been busy this year.

As equity markets declined double-digits through February, we increased our ownership of several businesses at lower prices. We purchased additional shares of Oaktree (OAK) and eBay (EBAY) as both stocks fell toward multi-year lows. We sold put options on other positions to capture elevated premiums and established a new position in American Express (AXP) using options to limit our capital at risk.

We put more cash to work after UK voters elected to leave the European Union, but a few days later, markets finished the first half near all-time highs. Given the rapid shift in sentiment despite little evidence of fundamental improvement, we took risk off the table as markets approached prior peaks. We completely exited three investments and trimmed one of our largest positions during the first half:

  • We liquidated Kennedy Wilson (KW) as the stock rallied from a low of $16 back toward $22. It would seem that the domestic real estate cycle is approaching the ninth inning.
  • We liquidated Fiat Chrysler (FCAU) above $8 after shares had fallen as low as $6 (and appear to be headed back in that direction). The auto cycle is well into extra innings.
  • We liquidated an investment in a closed-end high-yield bond fund, as credit markets recovered a good chunk of the ground lost during the previous twelve months.
  • We trimmed our position in CDK as shares rallied toward all-time highs, compliments of a letter to management from an activist shareholder.

Low interest rates and abundant credit have played a leading role in every financial bubble in history. Today, zero interest rates have succeeded in extending the cycle and pushing high prices higher. These trends can go on far longer than expected. Yet, once they run out of gas, they tend to unravel far faster than predicted. We are preparing for the inevitable reversal of these trends by holding more cash (even for us). Since forecasting a precise inflection point is likely to prove precisely wrong, a comfortable cash cushion helps us sleep at night while providing us with optionality on better prices ahead.

Avenues of Investment

In light of these views, we have begun tilting the portfolio toward investments less dependent upon rising asset prices. We first discussed this approach in a letter titled Avenues of Investment a few years ago.

Event-driven investments have a more specific time horizon than the high-quality compounders which comprise the majority of our portfolio. As a complement to our core portfolio, these positions are more predictable, both in terms of our potential earnings and our downside risk.

Over the past year, event-driven spreads have widened significantly given increasing regulatory and political challenges. Increased spreads should translate into increased returns. We also like the shorter duration of these situations. Our recent investment in EMC provides a good example. Shares traded between $24 and $28 during the first half. Assuming Dell’s announced acquisition of the company closes, we will get $24 in cash and the balance in what is effectively a VMware tracking stock for roughly 50% of the current price.

In addition to event-driven investments, options can also assist us in dampening volatility and shortening the duration of the portfolio. As discussed in that letter:

We use options in a simple manner to achieve a single objective: the reduction of risk. The majority of these positions are shaped by our research which indicates that selling puts can provide current income, reduce volatility and enhance returns in overvalued markets. Furthermore, if exercised, put options give us the right to buy companies we seek to own at prices we want to own them at; and when they are not exercised, we settle for handsome returns on our cash while waiting for lower prices and a wider margin of safety. In addition to put selling, we occasionally use options to exit positions by writing covered calls at strike prices near intrinsic value. In both cases, we are being paid to do something we would do anyway.

Given the low level of returns implied by today’s valuations, a few dollars in premium can significantly enhance performance. Consequently, we have become more active writing options this year. In the last six months, we sold put options on periodic spikes in downside volatility. We also sold call options as positions approached fair value and markets approached all-time highs. We discuss a few existing positions below.

Melting Ice Cubes

Apple, Gilead and eBay would appear to have very little in common at first pass. One designs cell phones. Another sells drugs to consumers. And the other sells stuff on eBay. All are victims of their own success. All generate high and consistent profit margins. All are conservatively financed with net cash on their balance sheets. All are led by disciplined management teams aggressively buying back undervalued shares. And all are priced as if they were melting ice cubes. In a world where most investors are betting on peak profit margins reaching new highs so that peak valuations are driven to new higher peaks, we are simply wagering that, in each of these situations, things may turn out less bad than expected.

Recall that the steady-state value of a firm is the value of the business assuming that it maintains a normalized level of profit into perpetuity. Historically, steady-state value has explained two-thirds to three quarters of the market’s value; future value creation accounts for the balance. Said differently, a long-term average price-to-earnings multiple of 16x implies a steady-state multiple of 10-12x.
We paid a single digit multiple of current profits for this portfolio of businesses. We paid nothing for future value creation. It is common to refer to such a scenario as a free option on future growth; but in this case we were actually being paid to own that option.

These businesses may in fact shrink over time. Apple is unlikely to ever repeat the success of the iPhone. Gilead is unlikely to ever discover a drug as successful as its HPV franchise. And suffice it to say that eBay is not (nor will it ever be) Amazon. But this first order thinking misses the point. These businesses don’t need to “succeed” to be profitable investments. They only need to be less bad or shrink slower than the market expects. Failure is only one potential outcome. Yet it is the outcome assigned the greatest odds by the market. There are several futures for each of these businesses where the market is too pessimistic. In each of these futures, we are poised to profit.

At current prices, the value drivers for each of these businesses is largely unrelated to the direction of interest rates or the general movement of the stock market. In addition, we have further reduced our sensitivity to the market and shortened our duration through the sale of options. Each of these investments has been structured similarly. Our investment in Apple is a useful illustration of our potential returns:

  • If the stock falls, we will own more shares at a net cost approaching $80.
  • If the stock rallies, we will earn a double-digit return in less than six months.
  • If the stock does nothing, we will earn a high single-digit return in less than six months.

This is a situation we would describe as heads I win . . . tails I still win. We make money if the stock goes up. We make money if the stock stays where it is. And if the stock falls, we collect some premium and increase our ownership at even lower prices. While we work hard to manage leaks in our investment process, “someone” in Omaha reported a large position in the stock within days of our purchase. Apple closed the quarter at $95 per share and has subsequently rallied to a high of $108.

Our top equity positions are largely unchanged since year-end. At quarter-end they were Oaktree, Time Warner, SeaWorld (we imagine we’ll have more to say on this one at year-end), CDK Global and eBay.

Please give us a call if you have any questions on the portfolio or just miss talking to us. We value your continued confidence and work hard to earn your trust each day.


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