What can bonds say about value?

I’m going to start including below a list of interesting articles I’ve been reading. I hope you enjoy them. On with today’s commentary:

One of the big evolutions in investor thinking happens when investors stop thinking about stocks as slips of paper to be traded back and forth, and instead view them as proportional shares in real operating businesses. To that end, a stock’s intrinsic value (what it’s worth) is simply the total of all its future earnings, expressed in today’s dollars.

In an excerpt below from a 1999 article penned for Fortune Magazine, Warren Buffett writes about understanding the return from these future cashflows in terms of the yield on a government bond:

The rates of return that investors need from any kind of investment are directly tied to the risk free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward.

Using this framework, we find that the higher the return on invested capital of a business, the more valuable the business – a rather common sense idea. For example, assume a “good” business is sustainably earning 20% on invested capital for its shareholders, while a “bad” business is earning only 4% on invested capital. If government bonds yield 4.6%, as they did a decade ago, then the good business is worth about 4x its invested capital (20% / 4.6% = 4x), and the bad business is worth about 0.9x its invested capital (4% / 4.6% = 0.9x). So if it takes $100 to start a business, then the good business should be worth about $400, and the bad business should be worth only $90. That’s right, in 2006, a bad business was worth less than the capital put into it!

If the yield on the government bond changes, the intrinsic values of business changes too. So if the yield falls to 1.6%, where it stands today, then the value of the good business rises to about 12.5x invested capital, while the value of the bad business rises to 2.5x invested capital. In this light, it’s plain to see how a low interest rate policy helps subsidize otherwise uneconomic business interests (or it at least gives them time to figure out how to get profitable!).

Some people are concerned that stocks today are trading at higher multiples than they were a decade ago. It is true; the average multiple is higher today. However what this concern fails to take into account is the effect of a lower bond yield on intrinsic values. As detailed above, falling interest rates mean that companies trading at 4x their capital today are very different fundamentally, and not directly comparable, to companies trading at 4x their capital a decade ago. This is one of the dangers in using things like the PE ratio to judge the health of the overall stock market through different times in history.

Higher multiples, on their own, are not necessarily a sign of overvaluation. A more rational approach would be to compare the multiple in context of the return on invested capital and government bond yield. From that perspective, it’s still business as usual.


What I’ve been reading this week:

Managing temperament is just as important as managing your portfolio: http://sethgodin.typepad.com/seths_blog/2016/08/temperament-is-a-skill.html

Maybe the drop in energy spending holds the potential for future inflation? http://www.bloomberg.com/news/articles/2016-09-19/at-500-million-a-pop-it-s-an-oil-gamble-that-has-no-precedent

People need to save more. http://www.bloomberg.com/news/articles/2016-09-20/make-six-figures-there-s-a-decent-chance-you-ve-got-almost-nothing-in-the-bank

Is real estate overvalued? http://ritholtz.com/2016/09/reits-are-awesome/

When do private mortgages become a public problem? http://www.theglobeandmail.com/report-on-business/joe-schmo-lenders-double-stake-in-canadas-mortgage-market/article31981959/

Boomers doubling down on illiquid assets…  http://business.financialpost.com/personal-finance/mortgages-real-estate/the-new-gamble-double-your-bet-on-the-housing-market-by-keeping-your-old-home-after-moving

Returns accrue to the most rational investors, not the ones with the highest IQs: http://www.nytimes.com/2016/09/18/opinion/sunday/the-difference-between-rationality-and-intelligence.html

Chasing growth doesn’t work. Return on capital is much better. http://latticework.com/the-sustainability-of-growth-vs-return-on-invested-capital/

Inspiration from Elon Musk: https://www.youtube.com/watch?v=tnBQmEqBCY0

Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc offering investment management and planning for high net worth Canadians. Ben focuses on the Growth and Income Portfolios and reducing tax.