Where the Value Is
Is value investing dead? And what does this have to do with low or negative interest rates?
December 13, 2019
Two questions seem to occupy pundits and popular media these days. One is why interest rates are negative and what this means. The other is whether value investing is dead. Answering the first question provides useful insights in dealing with the second question.
Negative interest rates on government bonds are observed in Europe and Japan, but not in North America. And there is a good reason for that.
The nominal interest rate is the reward one expects for making an investment. This reward consists of three sub rewards.
First is the reward for postponing consumption for the future, i.e., the real interest rate. Second is the reward for possible loss of purchasing power, i.e., the premium for expected inflation. And third is the reward for possible loss of capital, i.e., the risk premium – I will ignore the risk premium here as normally it does not apply when dealing with government bonds.
In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts the real interest rate falls. Yet, its long-term trend is affected by factors that change only slowly, namely technology and demographics.
In the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails, among other things, on productive capacity and the labour and commodities markets. In the long run, it is taxes, economic efficiency and productivity that impact inflationary expectations.
Currently, thanks to quantitative easing, there is too much money around (i.e., supply exceeds demand for funds). This imbalance drives real interest rates down. This is a global problem. However, on top of this, in the European and Japanese context, lack of economic growth exerts a further negative effect on real interest rates. Economic activity, while less robust than in the past, is not as weak in North America as it is in Europe and so the downward pressure on real interest rates at this point is less severe in North America than in Europe.
Long term, there are two counterbalancing forces that again impact Europe and Japan more than North America. On one hand, demographic developments are pushing the real interest rate trend higher in North America. Baby boomers, a mostly North American phenomenon, have started to retire (progressively in larger numbers) and have stopped saving; in fact, they are in their de-saving (consumption) years, which reduces the supply of funds. This happens in the face of increased demand for capital by corporations that need to embed new technologies into their production processes, as well as by governments that need to borrow to fund structural deficits.
To clear the demand-supply imbalance, the real interest-rate trend is pushed up.
On the other hand, and this impacts both Europeans and North Americans, an aging population spends less, borrows less and saves more. Older people tend to also be more risk averse. Longer life spans, greater economic disruptions and heightened uncertainty add to the risk aversion, particularly of older people, and may have made older people less certain about their ability to have money well into their retirement. As a result, they spend less and save more than previous generations. Overall then, the long-term trend on real interest rates seems to be neutral in North America, but very negative for Europe and Japan.
The above-mentioned reluctance to spend, along with business cycle weakness, particularly in Europe and Japan, and continued technological advancements, globalization and structural overcapacity issues, lead to lower inflation and expectations thereof.
Europe and Japan have stagnated economically given their many structural problems. The fear of deflation has made the risk premium for inflation negative. As a result, adding falling real interest rates to negative inflation premium leads to a negative nominal interest rate. This is not true for North America. Even though in the short-term real interest rates are falling, the fear of deflation is not as severe in North America — record low unemployment has started to push wages higher. Therefore, in my opinion, even though nominal interest rates are very low in North America, there is less risk of turning negative.
So how does all of this impact the so-called value (i.e., low price-to-book) stocks? Low interest rates (and fear of deflation) hit value stocks the most, while they benefit growth stocks the most.
Price-to-book ratios (and other related multiples) are a function of interest rates. As rates converge towards zero, the price-to-book ratios of all stocks rise significantly above historical levels. In this setting, companies with very low price-to-book ratios tend to be bad companies and “naively” investing in them by definition leads to underperformance. Additionally, price-to-book ratios are higher than they appear during periods of deflation for heavy asset companies like value companies. Therefore, when price-to-book ratios look like they are low, in fact they are not, as deflated asset values blow up price-to-book ratios.
At the same time, price-to-book ratios are also a function of the growth rate of earnings going forward. Firms for which markets expect low earnings growth going forward tend to have low multiples and vice versa — a relationship derived from the equity valuation model taught at every university around the globe. In fact, markets tend to be over-optimistic about growth for high multiple firms and over-pessimistic about growth for low multiple firms. Growth stocks’ optimistic growth rate assumption interacts with the record-low interest rates. Such interaction benefits growth stocks the most, as their future growth opportunities look very high in present value terms. As a result, investors tend to overvalue (and overpay for) high multiple firms and undervalue low multiple firms. Hence, the growth stocks’ higher returns.
Therefore, these two questions are inter-related and one cannot address one without addressing the other. Which leads to an interesting conjecture: What if we are, for the foreseeable future, in a low inflation, low interest rate environment, what does this mean for an investing strategy that “naively” considers only low price-to-book ratio stocks?
Fortunately, this is not what value investors do. The process they follow goes beyond “naively” investing in low price-to-book stocks. They invest in these stocks only if they meet a predetermined margin of safety requirement.