“Given the current interest rate environment and the projection of such, we think that the inclusion of an interest rate factor in the valuation of equities has become an important facet to consider – equities should no longer be valued in isolation anymore.”1
– Robert Shiller, Nobel Prize Laureate and Yale Professor
“Diversification and equity orientation represent important objective principles for long term investors. Diversification provides the free lunch of improved return and risk characteristics, while equity orientation promises the possibility of greater wealth accumulation.”2
– David Swensen, Chief Investment Officer of the $31.2 billion Yale University Endowment
New Lockdowns Don’t Phase the Stock Market
On October 29th France and Germany announced new month-long lockdown measures in an effort to curb another surge in COVID-19 cases and the resulting strain on their hospital systems. In both countries, hospital capacities rose to ~50% prompting a quick and decisive second quarantine.
I have been of the view that the second wave of lockdowns has been the biggest risk to markets for some time. Coronavirus cases have been on a sharp rise across Europe and the United States for the past couple of months. The stringent lockdowns now in effect across much of Europe will no doubt hamper their fledgling economic recovery. Despite this, the Euro Stoxx 600 Index (a broad measure of European stocks) has climbed over 12% since the day Emmanuel Macron and Angela Merkel announced their respective lockdowns. How is this possible?
Two positive developments can help explain the rise. There is also a third much more powerful and persistent force that will continue to drive equity markets. First, the contentious and highly anticipated U.S. election has come and gone, resulting in a divided government that should make it difficult to substantially raise individual and corporate taxes. Second, two leading vaccine candidates have produced encouraging trial results raising hopes of a return to a more normal world. Both of these events proved to be positive catalysts for the market, but for many businesses across Europe, these developments do little to help what will amount to another lost month of revenue and profits. While both are important factors to the movement of equity markets, the biggest force driving capital markets today is often overlooked by most individual investors.
The most important factor driving markets higher is the action taken by central banks. Low interest rates in the form of a 0% Federal Funds Rate and a 10 Year Treasury Yield of 0.90% has an extremely powerful and disproportionate impact on global capital flows. Large global capital allocators who would like to earn a return on their capital have been forced into riskier assets, as buying a 10 Year Treasury no longer provides a satisfactory return. Global central bankers and monetary policy experts are well aware of this and thus why cutting interest rates is and has been their primary tool to prop up financial assets over the past two decades.
Equity Valuations are Still Attractive Relative to Other Asset Classes
This is how big asset allocators think – capital will continue to flow to productive equity assets It’s amazing to think, but at the writing of this paper the S&P 500 has returned nearly 14% despite all of the challenges 2020 has presented. As I wrote back in August in our newsletter titled “Don’t Fight The Fed” much of this rise has been due to the very aggressive action taken by the Federal Reserve and U.S. Treasury to prop up/stimulate the U.S. economy. Both of these forces still remain and the ramifications are still very relevant. I believe high-quality U.S. equities will continue to see strong demand from large global investors.
For investors looking at the variety of valuation metrics for the stock market (such as the Price-to-Earnings ratio), they will see valuations at elevated levels. While it is important to pay attention to these metrics, it is even more important to view these metrics through greater context. For large capital allocators, the full array of asset classes compete for their capital and capital naturally flows to the most attractive areas fairly efficiently. Put simply, the two major asset classes that compete for capital are equities and fixed income. With fixed income providing such low prospective returns (10 Year U.S. Treasury at 0.9%) it only makes sense for equities to see their valuations rise. As the following chart shows, stock market valuations are still very attractive when compared to the yield available in the fixed income market.
Robert Shiller (winner of the 2013 Nobel Prize in Economics and Yale University Professor) recently published a research paper in conjunction with Barclays highlighting the significant gap between equity yields and bond yields. His research, which studies market data and returns going back several decades, shows that yield differentials tend to narrow and often precede periods of stronger equity returns. We agree, and in our view, the continued gap between equity and fixed income yields will continue to push investors into equities further bolstering returns for investors in high-quality equities.
Real Estate and Cap Rates Differentials
Valuations in real estate show a similar phenomenon. Although real estate markets adjust and move at a much slower pace than liquid financial markets, the gap between cap rates and interest rates should narrow over time. Cap rates (the earnings yield equivalent for real estate assets) have been steady despite the abrupt recession and now trade at the widest spread to interest rates in nearly two decades. Real estate investments all carry with them their own number of idiosyncratic drivers, and just like when investing in public equities, security selection is very important. That said, an opportunity to buy high-quality real estate with strong future cash flows appears to be emerging. If interest rates stay lower for longer cap rates will invariably head lower as well.
How You Invest is Important – Invest in Shares of Businesses that Grow in Value
“If a business does well, the stock eventually follows.” – Warren Buffett
Warren Buffett, the world’s most famous investor, has had a storied career and produced outstanding returns for shareholders through his conglomerate, Berkshire Hathaway. One aspect of his career that is particularly interesting is how his investment style has changed over time. Early on in his career, Buffett focused on buying very cheap securities, paying less attention to the business’ quality. He knew that if he bought a stock at a safe enough discount to its intrinsic value that stock would rerate and he could then do it all over again. As time went on, Buffett found it increasingly difficult to do this consistently and his investment style began to change. His focus shifted from one of owning very cheap businesses to one of owning GREAT businesses.
Buffett has famously said, “it’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price”. This is a really important concept and one that is central to how we allocate capital at Athos Capital Advisors. Investing in “compounding” businesses, as it is also known, has long been the best way to invest, yet it still remains a rarely practiced form of investing.
In an effort to illustrate how a great investment asset performs below is an example of an outstanding business that has compounded at an above-average rate and has provided exceptional returns for shareholders. The business is American Tower and a graphical depiction of the business cash flows and valuation provide an example of how outstanding stock market returns can be achieved.
The example of American Tower shows a very stable business that grows year in and year out. The company owns, operates, and leases communications towers across the world, leasing space to cellular companies such as AT&T and Verizon. Demand for tower space has increased at a very high and steady rate and shows no signs of slowing down with the advent of 5G technology and the ever-increasing demand for data transmission. This is a classic toll road business and the company has only two main competitors in the tower industry. American Tower has consistently grown cash flows at ~20% a year for over two decades. The valuation of the business has stayed roughly the same over this time period (free cash flow yield). Investors in the enterprise have enjoyed an excellent return – closely approximating the growth in cash flows. American Tower, which is organized as a REIT, pays nearly 90% of its growing cash flow out in the form of a dividend. This is a classic compounding, cash-generating machine.
American Tower is one example of the kind of companies we invest in at Athos Capital Advisors. Our approach is to invest in the very best companies in the stock market and patiently allow them to increase in value every year. Assume Valuations Stay the Same for High-Quality Assets – Growth in Cash Flows Will Provide Returns
Characteristics of a High-Quality Company:
- High returns on invested capital
- Sustainably high-profit margins
- Little to no cyclicality in revenues and profits
- Recurring revenues, pricing power, and high customer retention
At Athos Capital, we seek to invest in high-quality businesses with long runways of growth at reasonable valuations. If valuations stay the same (and I think there is a good chance valuations drift higher) the growth of these businesses should provide excellent returns. As we construct equity portfolios we focus on two groups of stocks that fit this mold:
- Large- & Mid-Cap, ultra-high quality, dividend-paying companies which grow business value 10-20% a year
- Small & Mid Cap, extremely dynamic, earlier stage, high growth companies which grow business value 20-50% a year
Investing Requires Patience
A little over three years ago we made a new investment in a recently IPO’d software company called Appian. The investment was sizable and made up a large portion of client portfolios. It has been a very volatile and bumpy ride, but it has paid off with the shares recently eclipsing $100. We made our first purchases at $20 a share and continued to accumulate shares throughout 2017 and 2018. I provide this as an example to show how important it is to have a long term orientation and make sure that you can endure periods of volatility when they occur. There were plenty of painful moments along the way from $20 to $100. My clients and I are glad we were able to weather the ups as well as the downs in order to achieve a very attractive return over three years. We wish we had never sold any shares!
We still remain optimistic about future returns for high-quality equities. There is no escaping the fact that we live in a low growth world. No doubt, much of this reality is being driven by very stubborn demographic trends. As a result, interest rates have been pushed to 0% for most of the developed world with little indication of rising anytime soon. This low-interest-rate environment has forced global capital allocators out of the risk spectrum and thus the very strong rebound in asset prices across riskier asset classes.
We believe today still offers attractive returns to long term oriented equity investors. Despite a low growth world it is possible to find outstanding companies with high secular growth prospects. At Athos Capital, we are focused on owning the highest quality growing segments of the equity market.
As always, we focus on asset quality first and then attempt to find attractive values within this selective universe of securities.
1 CAPE and the COVID-19 Pandemic Effect, Robert Shiller
2 Unconventional Success: A Fundamental Approach to Personal Investment, David F. Swensen