Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Bryan Rosengrant

“Imagine a bank that pays negative interest. In this upside-down world, borrowers get paid and savers penalized. Crazy as it sounds, several of Europe’s central banks cut key interest rates below zero in 2014, and now Japan has followed...some 500 million people in a quarter of the world economy (are) living with rates in the red.” -- Bloomberg

By Brian Nelson, CFA

In April 1979, Paul Volcker became the Chairman of the Federal Reserve, and after a series of rate hikes, the federal funds rate reached a high of 20 points by the end of the year and into 1980. Though the move was to combat double-digit inflation at the time, it’s worth pondering what such borrowing costs meant. In 1979 and 1980, the hurdle rate for new projects or new investments was at a minimum north of the risk-free rate of 20%, meaning that investors and entrepreneurs required returns that were much higher than those levels. Money came with a cost. Very few entities would seek a loan for 20%+ to pursue a project with a return of 5% or lower, for example. That’s called economic value destruction, a negative IRR proposition. Capital wasn’t sloshing around back then, being thrown at anything and everything.

Today, the situation is much different. A mid-single-digit return has become something equivalent to “hidden” treasure. With all-in borrowing costs, after tax, for some entities barely above zero, what one might describe as being low-return endeavors are now being pursued with absolute rigor and excitement. The Google’s (GOOG, GOOGL) and Apple’s (AAPL) of the world, for example, are dropping millions and millions in search of the “next big thing,” spending money like no other entity in the history of time. In the past few months alone, Apple, for example, dropped a cool $1 billion investment in Didi Chuxing, a Chinese transportation service and rival of Uber, and spent another $200 million on Turi, a “machine learning platform for developers and data scientists.” The rationale for the latter? “Apple buys smaller technology from time to time, and we general do not discuss our purpose of plans.” Hardly a sufficient answer to its owners, in my opinion. In the three months ending June 2016, Google lost ~$860 million on what it describes as “Other Bets.” That’s almost $1 billion!

Of course Apple and Google have a lot of money to spare, and both have fantastic balance sheets. Continuous innovation remains their lifeblood, and arguably, their balance sheets may be the strongest across our entire coverage universe. But that’s exactly what I’m getting at. Unlike perhaps at any of time in history, corporates have become willing to spend (and lose) hundreds of millions on acquisitions or new projects on a seeming whim, or lose hundreds of millions (or more) in a few short months in hopes of finding the “next big thing.” Forget about excess returns. The probability-weighted marginal return on such speculative investments may even be negative, and it gets worse: Not only are corporates flush with excess cash, but central banks are essentially “giving” money away to those that want it. Hundreds of millions, perhaps billions, of dollars are chasing every single possible idea out there, and as a result, excess returns are becoming harder and harder to come by. The cost of money is practically nil.

But why should you care as an investor? Well, the extremely “loose” lending environment around the globe has already had a profound impact on the success rate of the entrepreneurial community, making it harder and harder for those starting a new business from the ground up to compete with established entities with seemingly “free” and “infinite” access to capital. The impact on the traditional investment world and on the perception of what level of returns is “acceptable” is also quite noteworthy, however. At no time in my professional recollection, for example, has a 2%-3% yield been something to get head-over-heels excited about, especially in the context of what investors may yet not completely embrace: as owners of the company, they already own the dividend prior to it being paid. Please see: “Nelson’s Warning.”  With the world awash in excess capital chasing marginally-positive returns, if not risk- and inflation-adjusted negative ones, dividend yields are being bid lower and lower, and that means rising prices for dividend-paying equities as a result of the world’s “quest for positive yield.”

The evidence is striking. As of August 12, the forward 12-month price-to-earnings ratio on the S&P 500 (SPY) stood at 17.1 times, according to Factset, while the dividend-growth heavy consumer staples sector (XLP) is now trading at nearly 21 times forward 12-month earnings, above its 5-year and 10-year averages, which themselves are below that of the current valuation multiple on the S&P 500. These are multiples on forward earnings numbers, which factor in growth in the coming year, implying that valuations are far more stretched than the traditional 15 times trailing measure that many seasoned investors use as a benchmark for “fair valuation” across the market. Not only is the market overpriced by most measures, but dividend-paying equities are the most overpriced of them all. Times are great. Portfolio values are elevated. Equity investors of all types are getting rich. The stock market notches new high after new high. Time to pop the bubbly!

Obviously, we’re worried. The question to us is not whether a bubble exists or not. In our opinion, we’re currently in the midst of an “inflating” stock market bubble, and it may still inflate for some time to come, years even. Still, a mere reversion to mean multiple valuations, for example, could bring about a rather large disruption in the equity markets, but such a concern may only come to fruition under a scenario of aggressive contractionary monetary policy in the US (complicating the yield question for investors), which seems very unlikely in light of most of the world dealing with negative interest rate policy. What are we doing? Well, we continue to participate in this frothy market, but we’re paying very close attention to valuations and exposures as the market continues to overheat. Now is certainly not the time to forget about your investments! Keep your guard up.

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