A Winning Strategy Earnings, interest rates, investor psychology and the stock market
Mario J. Gabelli
From the Print Edition:
Kevin Spacey, Jan/Feb 02
(continued from page 1)
The stock market, as represented by popular indices such as the Dow Jones industrial average or Standard & Poor's 500, can be viewed both as a snapshot and as a motion picture. A recent snapshot has captured equities at their worst. However, Stock Market, the Movie has been a long-running hit, delivering annualized returns from 1926 through the first 10 months of 2001 approximating 11 percent. So, put your digital camera down, pick up your camcorder, and let's start videotaping the interplay of earnings, interest rates and investor psychology on the post-September 11 stock market. But first, let's place equities investing in the proper perspective.
In my opinion, the single best description of prudent equities investing is contained in two short paragraphs from Benjamin Graham's classic The Intelligent Investor, published in 1949: "Let us close this section with something in the nature of a parable. Imagine that you own a small share of a private company that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
"If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."
It is our, and every prudent investor's job to try to determine the intrinsic value of an individual company or the market as a whole. At any given point, intrinsic value is largely a function of earnings and interest rates. Whether stocks trade at, above or below intrinsic value is a function of investor psychology. Mr. Market is the code name the traditional value investor uses to personify investor psychology.
Graham and his colleague David Dodd, who co-authored Security Analysis, viewed stocks as pieces of businesses to be owned long-term, rather than pieces of paper to trade. Consequently, they saw little merit in assessing intrinsic value based on short-term earnings. Instead, they focused on what they termed "earnings power." Earnings power is determined by reviewing a company's earnings history, evaluating the health of its business and its competitive position within its industry, and then projecting a growth rate for future earnings. Were they alive today, Graham and Dodd would be asking the following questions regarding the earnings power of corporate America in a post September 11 economic environment:
How bad is bad?
How long will the difficulties last?
Are there financial resources available to overcome the challenges?
How good is good -- what happens to earnings growth rates once we emerge from this period of uncertainty?
Let's examine the current environment and try to answer the first three of these questions. The economy is in recession and corporate earnings are anemic. However, dealing from positions of strength -- subdued inflation and budget surpluses -- the Federal Reserve and federal government are pulling out all the stops to reinvigorate the economy. The Fed has injected massive liquidity into the system and as I write, cut short-term interest rates 10 times in 2001 for a total of 4 percent, leaving the Fed Funds rate at 2 percent as of early November. Perhaps more importantly, the Treasury has announced it will no longer be issuing 30-year bonds. This has brought long-term interest rates down, further fueling the home-mortgage refinancing boom that is putting a lot of money in consumer's pockets. Lower long-term interest rates also bring down the financial costs for corporations. This will have a favorable impact on future operating earnings, and eventually encourage business investment. Although there is currently some squabbling between Democrats and Republicans, Congress will pass a substantial economic stimulus package. Our conclusion is that we will experience a relatively modest, short-lived recession, with the economy and corporate earnings starting to recover in the second half of 2002.
How good is good? Corporate America has cut a lot of fat from the bone, which will create earnings leverage once demand recovers. Consequently, I think earnings will climb sharply in 2002. Over the long-term, I believe earnings growth will approximate 6 to 8 percent. If earnings recover as I anticipate, lower interest rates will have a beneficial impact on the present value of equity assets.
Interest Rates 101
Let's spend a few moments looking at what happens when interest rates decline:
Reduced Financial Costs. This helps highly leveraged companies by reducing interest outlays.
Improved Demand. Lower rates help stimulate demand for traditional, interest-sensitive economic sectors, including residential housing, a key and visible component.
Focus on dividends. Clearly, higher-yielding stocks with reasonable growth prospects benefit from investors who seek higher yields than they are getting from savings accounts.
Higher Asset Values. Lower rates bolster the value of assets.
Interest rates have declined to levels we have not seen in a long time. Short-term interest rates have not been this low since 1961. The story is similar for long-term interest rates. The 30-year Treasury bond was first issued in 1978 and it carried a coupon of 8.00 percent. These were known as the "8s of 08." Today, with a weak economy and the recent decision by the Treasury to halt the sale of 30-year bonds, we are looking at sub-5 percent yields on long-dated Treasury debt. In 1981, the 30-year bond, referred to by some as the "long guy," carried a 15 percent coupon; and 5-year Treasury notes were sold with a coupon of 16.125 percent. Rising productivity, low inflation and better fiscal and monetary discipline on the part of the Congress and Federal Reserve System all contributed to the truly incredible slide in interest rates.
Nominal interest rates, comprising "real" and "inflation" components, reflect the time value of money. There is a set schedule regarding the timing and the amount of cash flows from a straight bond. You get coupon payments with the highest degree of certainty -- at least with U.S. Treasuries -- on prescribed dates and your principal paid back at maturity. When you invest in stock, there is uncertainty with respect to the timing and level of the company's cash flow. Uncertainty means risk. Consequently, as a stock investor, your expected return (which unfortunately is not always realized) exceeds that which is available from a high-quality bond. This incremental return is called the "equity risk premium" and is one reason why interest rates are a very important influence on the general level of stock prices. To value a business, you must make an attempt to calculate the present value of a company's future cash flows.
Generally, low interest rates and low inflation support higher price-to-earnings (P/E) multiples and thus higher stock prices. The converse is also true. This historical relationship is shown on the chart below.
Consequently, rising rates are usually a negative for stocks and declining rates are usually, but not always, a positive. Declining rates may not prevent prices from falling if corporate profits are in free fall, a situation we experienced in 2001. Similarly, rising rates are not always bad, particularly in the early stages of an economic recovery when sharply rising earnings accompany them. But there is little doubt regarding the connection between the level and direction of interest rates and stock prices. The bull market in stocks that began in August of 1982 and continued for most of the next 17 years was driven by the combination of falling interest rates and rising profits, albeit the connection was not always in lock-step. It was almost too good to be true as the Dow Jones industrial average bolted from about 800 to over 11,000.
The discount rate used to calculate the present value of a company's cash-flow stream can be just as important as the earnings themselves. A simple example is to calculate the present value of $10,000, 10 years from now, with interest rates at both 15 percent and 5 percent. In a high-rate environment, using a 15 percent discount rate, the $10,000 of earnings a company generates 10 years out has a present value of $2,472. In contrast, using a 5 percent discount rate gives the earnings a present value of $6,139. In other words, a promise to receive $10,000 in 10 years has a higher value in current dollars when interest rates are low.
Thanks to the mathematics of compounding, lower rates are particularly positive for high-growth stocks because the present value of a rapidly rising earnings stream will be higher than the present value of a slower growing earnings stream, everything else being equal.
So the moral of the story is that declining interest rates are good for stocks in general but even better for "growth" stocks. The current bond yield environment is potential rocket fuel for quality growth stocks. It is also a strong tonic for stocks with reasonably good dividend yields, assuming such dividends are secured by earnings that cover the dividend payments with a healthy margin of safety.
Many years ago most stocks provided dividend yields that exceeded bond yields, making stocks attractive for income generation. Investors were not as comfortable with stocks then and demanded robust dividend payments to induce them to buy stocks. With money market and savings account yields hovering at or even below 2 percent, many investors can easily increase their income generation by reallocating assets to stocks with current dividend yields in excess of 2 percent. As dividends grow over time, the investors' income stream will grow in tandem. If income is an investment priority, it's time to think about adding some stocks to the mix.
Of course, intrinsic value and equities pricing are horses of two very different colors. Remember the emotional Mr. Market often values stocks materially above and substantially below intrinsic value. So, investor psychology will have a major impact on market trends in the year ahead.
Are investors ready to come back to the stock market? I think so. Investors are going to have to deal with another quarter or two of ugly earnings and ongoing concern over terrorism -- the fear factor that ultimately resulted in a classic "flight to quality" in the third quarter. However, when the political and economic dust settles, fear will likely give way to greed that will not be satisfied by today's anemic returns from bonds and money market funds.
In closing, I repeat my comments from the end of my last column in Cigar Aficionado: "Investors today are faced with an easy choice -- fretting over the short-term prospects for the economy and the market, or taking the longer view that recessions and bear markets present excellent long-term investment opportunities. It always takes courage to invest in depressed markets, but if you focus on fundamentally sound businesses trading at bargain prices, your courage is generally rewarded."
Mario J. Gabelli is the founder and chairman of Gabelli Funds Inc.