Dickens and the Return of the Coupon
Clients of the Firm,
Charles Dickens wrote that “it was the best of times, it was the worst of times.” Perhaps that is an appropriate description for today’s investment environment.
Higher interest rates are often described as a problem. For borrowers, they certainly can be. Higher rates increase the cost of mortgages, corporate debt, credit cards and government financing. They can slow economic activity, pressure businesses with weak balance sheets and make the mathematics of highly valued growth companies considerably less forgiving.
For investors, higher rates have brought something back into the financial landscape that was largely absent for much of the last fifteen years: the ability to earn a meaningful, relatively predictable return without taking substantial equity risk.
For years following the financial crisis, investors were effectively forced out on the risk curve. Cash yielded almost nothing. Treasury bills yielded almost nothing. High-quality bonds offered historically low returns. Investors seeking income were pushed toward equities, high-yield credit, real estate and other assets where the compensation for taking risk was sometimes surprisingly small.
After these many years, the yield opportunity has changed. A Treasury security can now provide a meaningful nominal return without the investor needing to make a heroic forecast about corporate earnings, artificial intelligence, geopolitics or the next move in the stock market.
Warren Buffett, who recently announced his transition to Chairman Emeritus of Berkshire Hathaway, has been one of the clearest thinkers on this subject. He is revered not simply because of his extraordinary investment record, but because of the consistency and common sense of his framework. We congratulate him on his incredible career and his thoughtful master class in corporate governance and leadership transition at Berkshire.
In 1999, Buffett wrote that interest rates “act on financial valuations the way gravity acts on matter.” When the risk-free rate rises, the prices investors are willing to pay for other assets generally have to adjust to reflect that.
This is an important concept in today’s investment environment. The prospect of a dollar of earnings five or ten years from now is less valuable when an investor can earn a substantial return simply by owning a Treasury security today.
Of note, tax efficiency of equity ownership remains favorable at the federal and state level as dividends are taxed at lower rates than interest. In addition, long-term capital gains are taxed favorably and can be managed over time to fit a client specific tax situation.
The mathematics of valuation are not complicated. The higher the discount rate, the less investors should be willing to pay today for a distant stream of prospective future cash flows. Buffett made essentially this same observation at Berkshire Hathaway’s 2016 annual meeting, noting that investors would pay more for a business when interest rates were near zero than when rates were at historically normal levels. He described it thus, “Very cheap money makes me pay a little more for businesses.”
The reverse is also true. Our valuation modeling considers higher rates in two ways: multiple contraction and higher discount rates. This does not mean that stocks cannot rise when interest rates are high. Nor does it mean that every expensive company is a poor investment. Exceptional businesses can grow their earnings, generate enormous amounts of cash and justify valuations that would be inappropriate for an ordinary company.
For example, a company trading at 35 times earnings must produce considerably more economic profits than a company purchased at 15 times earnings for that investment to work out well. When the risk-free rate was near zero, investors had little alternative to accepting that valuation risk. This was called TINA (there is no alternative). Today, investors have an alternative, higher rates represent a meaningful change in the opportunity set.
Higher interest rates also influence the economy through a more familiar channel. Borrowing becomes more expensive. Consumers become more cautious. Businesses scrutinize capital expenditures carefully. Housing activity can slow. Highly leveraged companies face higher interest expenses. Eventually, these forces can reduce aggregate demand. That said, the economy is not simply a collection of borrowers. It is also a collection of investors.
The millions of Americans who hold cash, Treasury securities, money-market funds, CDs and high-quality bonds now receive much more income on their capital than during the zero-rate era.
As noted in our previous K-economy letter, this dynamic creates an interesting transfer within the economy. For someone carrying a large variable-rate debt balance, higher rates are a headwind. For someone with substantial savings, they can be a tailwind.
We believe this rate paradigm shift is one of the most important developments for investors. An investor does not necessarily need to take equity-market risk to generate a meaningful return on capital. Long term investors are compelled to ask: What return can I earn today without making a forecast?
Treasuries and carefully selected investment-grade corporate bonds can provide substantially more predictable cash flows than many stocks. There is an important distinction here. A stock dividend is not a contractual obligation in the same way that a bond's interest payment is. A company can reduce or eliminate its dividend. A bond issuer, subject to credit risk, has a contractual obligation to make its scheduled payments.
For the better part of a generation, investors were taught that the only way to generate meaningful returns was to accept substantial market risk.
The return of a meaningful risk-free rate changes the landscape. It allows investors to build portfolios around a foundation of contractual or highly predictable cash flows, evolving the role that equities play in the overall portfolio. Rather than owning stocks because they must provide income, one can own stocks primarily for long-term growth and inflation protection. Investors can patiently seek the best valuations while being paid to wait.
Charles Dickens began A Tale of Two Cities by writing of “the best of times” and “the worst of times.” Markets have always contained both. For investors willing to look beyond the daily headlines, today's higher-rate environment contains a similar contradiction. Higher rates create challenges, but they also create income.
Sincerely,
Peter Wernau
CEO
Wernau Asset Management
30 Western Ave, Suite 206
Gloucester, MA 01930
Direct: 978-325-6049
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