Uncertainty is Our Friend… I Think.
The last few months in the market should be enough to shake anyone’s confidence that they can predict the future. This has been demonstrated in dramatic fashion by the rush toward certainty at any cost. Investors now want certainty so badly that portfolio managers around the world, according to Deutsche Bank, have invested $15 trillion at a quoted yield-to-maturity that is below zero as of September 2019. Not only do below zero interest rates cause a variety of quantitative valuation models literally to breakdown, but they also fail to pass the grandmother test, in that my grandmother does not understand how in the world she can pay back less money than she borrows. Of course, she’s smart enough to immediately ask to borrow a lot of money.
Certainty is expensive. When lenders are willing to pay you to safeguard their money, instead of demanding a return, it’s a hint that certainty has become perhaps a bit too expensive. My bond buddies tell me that it’s not the rates themselves, but the spread to longer maturities that are forcing short-term rates below zero. My grandmother is not convinced. On the other hand, the math says that if the coupons on a long bond are invested at positive rates, and not the negative yield to maturity that is quoted, that the actual compound return, or realized compound yield will still be positive. Grandma does not understand that.
Ultimately, the flip side of certainty that is too expensive should be poor long-term returns. But while current rates keep falling, the low coupon returns are kept at bay by rising asset values, and momentum buyers keep buying regardless of the quoted yield. Encouraging buyers is the fact that many valuation models start to go parabolic on the upside with quarter point rate drops from such a low base, as demonstrated by the strong long bond returns this year. So, while certainty should provide a lower return, the growing demand for assets with certain cashflows has pushed prices and returns up and yields down. Another contributor to negative rates is the excess supply of capital created by the biggest generation of capitalists in history. As they move toward retirement, they need more certainty, not necessarily more return. So, in effect, low rates may simply be an excess supply driven price decline. If so, the floor to negative rates is the point when building a safe and hiring security is less expensive than the loss on the loan. But this is so unusual that the Bank of England had not offered rates below 2% in over 300 years until just recently, a time which also enjoys the most excess capital in history.
It’s equally confusing in the stock market. Our strategies underperformed in the third quarter ended September 30, 2019, with our Small-Cap Value Diversified strategy losing 2.11% vs. the Russell 2000 Value loss of 0.57%. Our concentrated Small-Cap Value Focus lost 5.26% in the quarter. After a strong first half, our strategies in the third quarter were buffeted by growing fears of recession, a recurring theme at several points during the past few years as the length of the recovery goes into record territory. Initially, the market focused just on the length of the recovery as a predictor of recession, although now there are a few data points coming out of Europe and China that suggest an increasing probability of recession.
Still, the current fears are so strong that we now have many holdings trading at 20-30% cashflow yields, as measured by EBITDA divided by Enterprise Value, meaning if we bought the entire company, we would earn 20-30% on our cash investment, a cash-on-cash return. While this return is before cash interest and capital investments, these are extraordinary return levels and can only possibly reflect a few scenarios. One scenario is that EBITDA for these companies falls 70% or more and the yields move toward a more traditional 10% EBITDA yield, or 10x EBITDA, still beating most bonds by the way – an unlikely scenario in our view. Another scenario is that rates rise a lot, putting lots of pressure on future earnings multiples. The problem with that is that the excess supply of capital likely prevents rates on certain cashflow streams from getting too high. So, what we are left with in order to equate low or negative short-term government rates around the world to unusually high cashflow yields among small best-in-class companies is that the risk premium to own small equities is among the highest we’ve seen in 10 years. Here’s where the title comes in: the uncertainty in the market has pushed the expected return premium on our small-cap equity universe versus a risk-free government security to historically high levels and we are excited about that. We own quality companies that tend to grow asset values even during periods when the market doesn’t recognize it.
It’s worth pointing out that recessions are not that bad. Excluding 2008-09 as a mistake by accountants clinging to a mark-to-market rule for too long, most other recent recession have been reasonably mild and getting farther apart. While there are many theories about the causes behind fewer recessions, one view is that more timely information available through the internet is creating less uncertainty all along the supply chain, leaving fewer opportunities for inventory dislocations that cause recession, and therefore continuing the trends of more years between recession as a natural outgrowth of better information. As we discussed last quarter, the economy still looks pretty good. We see a full employment economy with low interest rates, good access to credit, U.S. energy self-sufficiency, and a well-educated growing population. These are usually good elements for continued economic growth.
With regards to a market outlook, the stock market, according to Ben Graham, is a voting machine in the short term and a weighing machine in the long run. We subscribe to that view. In the near term, headline risk of shifting interest rates, trade wars, hot wars, oil shocks, tweet streams, elections –all impact the stock market in ways that often look very much like random. In the long run, population growth times productivity growth equals GDP growth, and businesses and industries that manage to do things faster, better or cheaper than alternatives will gain share of the economy and prosper. In the long run, we believe that better education, better access to information, and easier access to collaboration will create an acceleration in innovation and productivity, even as academics find it difficult to measure. The benefits of the app Open Table, for example, struggle to find a way into GDP. The time we all save to work on other projects or read a book gets lost in translation. But these entrenched trends will, in our opinion, continue to drive the economy to new heights, in the long run.
During these uncertain times, we strive to earn excess returns for our clients by continuing to do what we have been doing for nearly 20 years. We use a consistent process that fundamental investors have used for a long time. Between Ben Graham’s “margin of safety” and John Burr Williams’ discovery of the discounted cashflow model, we use tools that have been honed by time. Although markets have become more efficient, our universe includes some of the last eddies of opportunity to uncover information that has not yet been absorbed into market prices and we use fundamental research to find those opportunities for excess return. By identifying undervalued companies with good balance sheets that target growing industries and offer products or services that are better, cheaper, or faster than the competition, we have a universe of superior businesses that we believe on average will prosper in the future. By exercising discipline around our valuation approach and narrowing the bell curve around our estimates of intrinsic value, we rely on our expected return estimates to allow us to continue to buy stocks that we believe will deliver excess return over time. Uncertainty has driven the expected inflation adjusted return on our universe to levels that have rarely been higher. Does that make uncertainty our friend? For small-cap investors the answer is almost certainly, yes. Thank you for your interest in Sterling Partners Equity Advisors.
Kevin E. Silverman, CFA
Chief Investment Officer
John A. Schattenfield
Head of Distribution