Thursday, November 3rd, 2016
We believe the world is finally witnessing the end of the global multi-decade bond rally that has helped shape the investing environment as we know it today. To put it more simply, we believe global interest rates and bond yields have probably bottomed. There are many in the market however, who believe the recent sell-off in bonds is yet another false dawn, as was the case throughout 2013 and during the middle of last year. Yet, with the US Federal Reserve (Fed) inching closer to a December rate hike, and the European Central Bank (ECB) seemingly reaching the limits of its quantitative easing crusade, we believe the inflated bond market is much more likely to go down in value from here.
Figure 1. Long term government bond yields, 1996-2016
If our thesis is correct, it could cause a gradual reversal of the mass migration into the stock market by income-seeking investors. But less obviously, it may also affect asset prices by increasing the returns required by shareholders to invest their capital. One way this manifests is through the discount rates applied to valuations. The concept of a discount rate is simple – capital (money) has a time value. One dollar today is worth more than the same dollar in the future because of its potential earning capacity in the interim. If I have that dollar today, I can invest it however I wish. If that dollar is invested elsewhere, that potential is lost. In economics, this is known as the opportunity cost.
When this concept is applied to shares, many investors generally seek to identify a discount rate that adequately compensates them for:
- Taking their capital out of so-called risk-free assets such as government bonds or cash.
- Putting their capital into shares, a relatively risky asset class.
- Putting their capital into a specific company/stock, which carries specific risks.
The opportunity cost of not investing in ‘risk-free’ assets is typically estimated using long term government bond yields. It is logical to assume that because an investor can park their money in assets with little to no risk, the return they demand on shares should logically be higher. This forms the base of the discount rate, or in another manner of speaking, the required return. We believe a good proxy for the risk free rate in Australia is the 10-year government bond rate. Clime employs a blended average of the current (“spot”) yield on such bonds and the long term historical average. A recent 2015 survey showed around 88% of investment professionals used the 10-year rate and of those, almost 40% use the spot rate, with 35% using an approach similar to our own.
Figures 2 & 3. 2015 market survey on proxies chosen to estimate the risk free rate
The second component of most discount rates is the equity market risk premium (EMRP). Essentially this is the premium investors require for exposing their capital to the risks associated with the stock market. Typically, this is calculated by looking at the difference in returns from the stock market versus the risk free rate over a defined period of time. Many calculations also include country risk premiums which are often based on the credit ratings of government debt. In Australia, a premium of 6% is typically adopted, though 5% and 7% are also sometimes used.
Figure 4. 2015 market survey on EMRP adopted in valuations
The third component of the discount rate, which attempts to compensate investors for the specific risks associated with individual stocks, is where approaches can diverge significantly. The idea here is to determine how much additional return is required to invest in a single stock as opposed to the stock market itself. Because of this, the most popularly used risk factor is beta which tracks the price sensitivity of an individual stock relative to movements in the broader market. Beta has been used since the ‘50s but has long been acknowledged as painting an incomplete picture of company risk. Under our own proprietary approach, we consider a multitude of fundamental risk factors ranging from size to financial leverage, earnings volatility and cash flows.
Figure 5. StocksInValue’s required return model
Source: Clime research
Our analysis yields what we term a ‘required return on equity’, also known as the cost of equity. In fundamental models, this is used to discount cash flows or earnings from companies in order to present value in today’s terms. It is often the trickiest and most subjective aspect of financial modelling due to the fact that small changes to the discount rate can produce material changes to valuations.
With that in mind, changes to the risk free proxy, caused by a reversal of the decades-long bond rally, would have a significant impact on valuations. If the yields on bonds rise, then the return required from equities must too increase. Understanding this relationship is fundamental to understanding the market today and indeed the principles of value investing. Yield compression in bonds has reduced required returns, allowing valuations to rise materially over recent years. If bond yields have indeed bottomed, required returns may need to rise as well, potentially creating a powerful headwind in equity markets. Stocks priced primarily on yield, such as large cap property, infrastructure and packaging, are most at risk under such a scenario. To illustrate this point, the pricing model below looks at Transurban Group, one of the most popular defensive income stocks in Australia, in terms of the return (yield) investors could be expected to demand under different long term bond yields.
Figure 6. TCL – implied share price based on 10-year government bond rate
Source: Clime estimates
In the above example, if one uses a 10-year bond rate of 2.33% (the spot rate at time of writing), Transurban’s price should be around $10.94. But if one uses a 10-year bond rate of 3.5%, Transurban’s price is best estimated at around $8.79. This may seem like an extreme example, but it demonstrates the concept of required returns well. Indeed, the average Australian 10-year bond rate over the last 10-years is 5.08%.
Discount rates are comprised of a risk free rate, market risk premium and company specific risks. If one or more of these factors changes, valuations will too. As valuye investors, we believe understanding this is essential when making longer term portfolio decisions, including where to allocate capital and how to plan for the probable rise in required returns as bond markets finally run out of steam.