The Fed’s abrupt U-turn six months ago turned night into day, down into up, bear into bull. As Magellan's Hamish Douglass put it in this interview:
“...the Fed completely changed the game and effectively says we're not going have any more rate rises. I said to the team, it's like what Mike Tyson said: “Everybody has a plan until you get punched in the mouth”.
In that quote, Tyson was talking down the fight plan of his future opponent Evander Holyfield. But it was the man with the plan that won the fight that night. So, with the Fed having changed what the next few years look like, what’s the new fight plan? Hamish Douglass discusses here how he's rolled with the punches to stay on top.
The full video (and transcript) below is well worth a watch (or read), but here are a few key take-outs.
The new fight plan
After getting accustomed to rates rising, the narrative changed overnight in late 2018. Suddenly we were considering a rate cutting cycle, and reading headlines with acronyms like ZIRP and NIRP. Having climbed steadily from 1.4% to 3.2% over 2 years, the US 10-year bond yield plunged back to 2.0%.
US 10-year yield heading South again
It’s an asset allocation headache. Holding cash suddenly looks like a liability, while risk assets are back on the menu. As Hamish Douglass said here:
“Effectively we had a portfolio positioning at the beginning of this year that was heavily in cash and expecting rates to go up and we were going to deploy them as rates went up. And the Fed effectively changed what the next few years were looking like. And we made a decision that 20% in cash was a wrong place to be”.
It’s not just that a lower bond yield makes the yield on equities look relatively more attractive, but the US 10-year 'risk-free rate' is a key input into equity valuation models. Lower rates support high valuations. So, could a new cutting cycle mark the start of a renewed multi-year equity bull market? In the video Douglass cited an extreme scenario where valuation methodologies can start to enter the twilight zone:
“...for businesses that are growing more strongly, we approach something that is known as a Petersburg paradox that as the growth rate starts approaching the discount rate, theoretically a business could be worth infinity on a net present value basis”.
While asking your broker to put a sell order on at 'infinity' could give you a great story for your next long lunch, it’s not an entirely practical situation. However, this theoretical situation gives you a sense of the potential trend for equity prices, not least where valuation models are highly sensitive to falls in rates.
"So a business growing at 6% per annum or 7% per annum, and that could happen for an extended period of time, by 20 years, if you could find those businesses (and we've invested in Visa or Mastercard for the last decade that have grown their revenues at 12% per annum), so if we can find a business that could average at 6% or 7% or 8% per annum for the next 20 years, and if interest rates are going to be lower, the valuations on those businesses are potentially very, very high”.
The 12-minute video is worth a watch to get the full picture of his long-term rate expectations and fundamental drivers, the impact on asset allocation decisions, some specific stock examples that could benefit, as well as why the inexorable rise of China is “one of the most important investment areas to get right over the next 10 to 20 years”.
Matthew Webb: I'd like to talk to you firstly about the big reversal we saw from the Fed earlier this year. I'm interested in your thoughts on what that means for stock valuations.
Hamish Douglass: Well, it's a very important topic. Where level of long-term interest rates are is a crucial element of judgement. Ultimately, as Warren Buffet describes, interest rates are the gravity of markets. The lower interest rates are, the higher valuations are, and in fact, the higher interest rates, the lower valuations are.
Just to put this problem into context, let's say we've got a company that could grow at 4% per annum forever. So effectively we know the coupons on this equity bond give you a 4% growth forever. Very difficult to find those businesses, by the way. But I'm simplifying the assumptions. If we were in a long-term interest rate world of maybe 5%, and you add a market risk premium of 5%, that 4% growth would be multiplied at about 16.6 times its free cash flow. So at a 5% risk free world, that 4% growing business would be worth around 16.6 to 16.7 times free cash flow. Not earnings but free cash flow.
Now let's say rates are 4% and not 5%. That exact same business with exactly the same cashflows would now be worth 20 times free cash flow. And if interest rates were 3%, which means you're probably looking at an 8% sort of cost of capital, in that world you're probably looking at 25 times. And if rates were down at 2% where they are today, that same business would be worth around 33 times.
So a change in interest rates from 5% to 2% long term interest rates, which changed the valuation metrics for a 4% growing business from 16.6 times to 33 times earnings for exactly the same business producing exactly the same cash flows. So our job as investors is first for our analysts to try and understand the long-term trajectory of these businesses and to estimate how much cash these businesses will produce over time. The interest rate at which you're assuming is very, very important and I can tell you with quite a degree of confidence, long-term interest rates are going to be somewhere between 2% and 5%.
Now the question is do I pay 16 times or do I pay 33 times for that 4% growing business? That's a pretty wide range here. Our market's undervalued or overvalued at the moment.
What the Fed is doing is probably flattening out the short-term interest rate cycle with its moves in January. So we're probably lowering our expectations of where that short-term interest rate cycle's going to go at the moment. But we are also, not just due to what the Fed is down at the moment, but some very long-term structural events that are happening in the world, we are lowering our range of long-term interest rates in which we are viewing the valuations of stocks.
This becomes even more important because as long-term interest rates are lower, for businesses that are growing more strongly, we approach something that is known as a Petersburg paradox. That as the growth rate starts approaching the discount rate, theoretically a business could be worth infinity on a net present value basis. So a business had growing at 6% per annum or 7% per annum and that could happen for an extended period of time, by 20 years if you could find those businesses, and we've invested in Visa or Mastercard for the last decade that have grown their revenues at 12% per annum. So if we can find a business that could average at 6% or 7% or 8% per annum for the next 20 years, and if interest rates are going to be lower, the valuations on those businesses are potentially very, very high.
So this is a really important question about where long-term interest rates, we use a range, and the range we have lowered over the last 18 months. It's actually been coming down over the last 10 years. We're not reaching into where current interest rates are in Europe and Japan, long-term bond rates are negative at the moment. Well, you get silly numbers on that. And in the United States have fallen from about 3% down to 2% after the Fed has made this U-turn. I can tell you we're not at those levels in our valuations, but we have lowered our long-term expectations modestly but it's very, very important, this question. I don't think anyone knows what the answer actually is going to be. You really have to think about it.
Matthew Webb: You've alluded to the change in rate view impacting different companies in different ways. I'm curious as to what that's meant from a portfolio perspective as the portfolio manager of the Magellan global strategy.
Hamish Douglass: Well, it's interesting. Through 2018, we were holding, by the end of the year, up to 20% in cash. And it was our view because the short-term interest rate cycle was likely to be short-term interest rates were going up, which was going to push up the 10 year bond rate, we were very, very concerned of the impact that was going to have on markets as the Fed was increasing interest rates.
So if you think about our portfolio construction, we're around 30% in sort of defensive businesses like consumer staples in our portfolio, like Crown Castle and infrastructure assets, maybe a Yum! Brands or a McDonald's. We're only 30% weighted in that and we were 20% in cash at the end of last year and we were 50% weighted towards more of our technology in our growth portfolio. We were planning to effectively gradually increase our exposure to those defensive assets as interest rates went up.
And then we get into late January and the Fed completely changes the game and effectively says we're not gonna have any more rate rises. And I say to the team, it's like what Mike Tyson says, is everybody has a plan until you get in the ring and when you get in the ring you get punched in the face and everything gets thrown out in the water. And effectively we had a portfolio positioning at the beginning of this year that was heavily in cash and expecting rates to go up and we were going to deploy them as rates went up. And the Fed effectively changed what the next few years were looking like.
And we made a decision that 20% in cash was a wrong place to be. And if you look at 30 June this year, you'll see we're now less than 10% in cash and the defensive equity portfolio is now over 40%. We're still around 50 in the growth assets. We've changed a few things but largely kept the composition of that the same but we've bought a series of defensive businesses since sort of beginning of February. And it's been very, very difficult because bond markets had been rallying and many of these prices have been moving materially. And people will see we bought businesses, like PepsiCo and Heineken. I don't want to give it all away. There are a few more surprises in there as well and people will have to see what we reveal at an individual name. But the names don't matter as much as in terms of changing the positioning as the game got changed this year.
Matthew Webb: I'm going to change tack a bit now to sort of geopolitical events and we've seen a lot of rhetoric around the trade war between the US and China. I'm just curious as to what your views are on that today.
Hamish Douglass: Look, I think we have to separate the trade war between the short-term and the long-term issues here. There are very deep long term strategic issues and there'll be ongoing issues between the United States and China, and I would argue probably between other countries and China as well. China is a rising country and it's a rising economic power in world and a geopolitical power in the world and it is seriously challenging the world order from the United States perspective. And there are fair arguments that they are gaining their economic might not with a level playing field and that's a lot what the trade dispute's about that. But it's wider than just the economics of this trade dispute. And whatever happens in the short-term, that long-term issue is almost unresolvable. China is not going to back off and the United States isn't going to stop feeling challenged for its number one place in the world.
The reason that's a very important issue is because the rise of China isn't going to stop even though it may have economic cycles and it's one of the most important investment areas to get right over the next 10 to 20 years. You do want to participate in that rise of China economically, but you may not want to do it with a US flag wrapped all around your investments because of this challenge. So that's the long-term issue. The short-term issue is are we going to have a ceasefire or a truce? Trump has brought this issue right out into the open. He's taking them on, trying to level the playing field. He's doing it in a very, very heavy handed way with the Chinese, with the tariffs that have been put on. The issue you have to think about for markets in the short-term is are we going to get a truce or not or are we going to get an escalation of the situation?
I would say the most likely decision on that will be Trump's decision, not China's. China will want a truce here. They'll want a truce here. It's a domestic political call for Trump. What's he want going into 2020? He wants a strong stock market, to start with, but he does want, I think, a dispute with China that he is fighting for the rights of workers. So both of those things are potentially in conflict. While the stock market is strong, and if he leans on the Fed and the Fed cuts interest rates, he may feel upping the ante with China is in his interests. If the stock market starts to weaken or the Chinese do something to start to really play hardball and he wants to take them on in that in the negotiations, then he may keep the fight going through 2020. There are circumstances where that could be quite ugly for markets. So let's see what happens. It's, it's a very interesting game to watch at. We're not that concerned about the short-term. We're long term investors, but it will influence how the Fed and things acts in this part of the cycle