IVA Funds newsletter for December 2015 titled, “Do Low Rates Truly Justify Higher Valuations?”
Since the financial crisis, Central Banks around the world have launched various forms of “Quantitative Easing,” driving interest rates in developed countries to ultra-low levels, manipulating currencies worldwide and injecting massive amounts of liquidity. The growth in popularity of the “Fed Model” (a valuation model which compares the yield on 10 year Treasury bonds to the stock market’s earnings yield) over the past 30 years has led some investors to justify using higher market multiples to price securities, bidding up the price of many stocks. Some believe that even if stocks do manage to deliver returns of 3% to 5%, that would be better than holding cash which offers a negative yield after inflation. The argument that higher valuations are justifiable and that equity markets will be OK as long as rates stay low is at best a relative argument and at worst a dangerous one. We think better questions to consider are: Why are interest rates so low? Why do so many Central Banks around the world practice “Quantitative Easing” and “Financial Repression”? We believe that low rates today are symptomatic of a world where economic and financial imbalances may be bigger than ever.
The Bank for International Settlements’ (BIS) most recent annual report dated June 28, 2015 says it best: The key sign may be the buildup of financial imbalances. This also means that rates are low today, at least in part, because they were too low in the past. Low rates beget still low rates. In this sense, low rates are self-validating given the sign of financial imbalances in several parts of the world. There is a troubling element of deja vu in all of this.
Due to these concerns, coupled with other troubling factors (record high corporate profit margins and serious questions facing China and many Emerging Markets), both of our funds have pretty low equity exposures (51.6% in the Worldwide Fund and 51.8% in the International Fund as of September 30, 2015). Charles de Vaulx explains, “the idea that because rates are low we should use higher multiples to value businesses and also accept more modest margins of safety than otherwise, has no appeal to us. That idea frankly strikes us as being a trap.” We at IVA Funds see no reason to overlook fundamentals in the search for yield, and no reason to abandon a time tested approach based on discipline, reason and logic. Considering today’s fragile world, it’s our view that one should be paid more for risk rather than less. In other words, maybe the risk-free rate is low (and that is assuming it is not an artificially low and manipulated rate), but the equity-risk premium should be higher.
Anyone involved in Japanese equities from 1990 until 2012 could attest to the fact that low interest rates not only did not justify high valuations but also can be accompanied by a brutal and long lasting bear market. Over the past year, the ultra-low interest rate environment has not prevented some equities from coming down. Interest rate sensitive sectors (“yield plays”) like Master Limited Partnerships (MLPs) or Real Estate Investment Trusts (REITs) fell sharply without interest rates rising at all. The price of many commodities (oil, natural gas, copper, iron ore, etc.) have also collapsed. Low rates have made it possible for energy and mining companies to borrow huge amounts of money to expand their capacity, resulting in additional supply that is currently exceeding demand. A recent statistic from the BIS states that the total public and private debt relative to GDP for the entire world economy now stands at 265%, up from 219% at the peak of the prior credit cycle. This increase in debt occurred while the rate of economic growth decelerated. In other words, ever larger incremental amounts of debt are needed to produce less and less economic growth. This is not a healthy omen.
Trust us, we understand how seductive low rates can be. We hear the Sirens calling – “why not accept a fully or even overpriced equity instead of a negative real yield on cash?” Like Odysseus on his long and famous journey, we stay the course, navigate the waters and do not fall victim to the Sirens’ song. We have not and will not adjust our multiples based on low interest rates. As the price of asset classes and individual securities have been driven up in this environment, our job has gotten harder. We look at thousands of individual securities globally and are struggling to find genuine bargains, i.e. stocks offering at least a 30% discount to our intrinsic value estimates. Instead of accepting more modest margins of safety, we have remained vigilant in our approach. As long as we are not able to find enough safe and cheap new securities, we are willing to let cash levels remain at elevated levels. Thus, cash is a residual that cannot only act as a buffer when markets decline, but is also the ammunition to buy future bargains. We will be eager to deploy that cash when we believe that we are being properly compensated to do so.
We understand that high cash levels can be difficult for some clients to accept. When interest rates are low, people do not want to hold cash. For many, investing becomes a relative game and fundamentals are overlooked in a desperate quest for return. Low interest rates become too easy of a justification. At IVA Funds, our focus continues to be on preserving our clients’ capital over the short term and compounding their wealth in real terms over a full economic cycle. We will continue to attempt to do this by remaining disciplined in our approach, exercising patience and searching for quality opportunities at prices that offer a suitable margin of safety.