Monday, 3 October 2016

Expert opinions (on Price to Earnings) and their basis

First it was my old acquaintance, Rakesh and his friend- the self-styled Warren Buffet of India and then it was Mark from the famous American mutual fund, all asserting effectively the following: Interest rates are low and are heading lower, thus price to earnings (PE) need to acknowledge this and adjust upwards, basically to paraphrase these gentlemen (Mark specifically) interest rates at 1 % justify price to earnings of 100 times.

I tolerated all the while, till Mark decided to add his two bits to the argument, that’s when I decided I had, had enough. Do these gentlemen consider the rest of us to be such simpletons as to be misled by a clearly suspect assertion? Granted the media considers these gentlemen gods at investing, yet why weren’t they questioned on the basis of their conclusion even once. Or does reporting only involve reporting opinions and not questioning facts.

Let’s examine the above gentlemen’s assertions, related to interest rates and price to earnings, in context of current times, by answering a few basic questions. Where are we today in the interest rate cycle?, Are current rates incorporated in valuation models by analyst?, Do lower interest rates mean higher price to earnings in stock markets around the world?

For the first question, where are we today in the interest rate cycle worldwide? The ten year government bond yields are a good indicator of the effective risk free rates in various countries. Today the ten year Japanese Government Bond yield is at minus 0.10%, Germany the leading European nation has its ten year at minus 0.12% and US ten year is at a yield of 1.59%.  When one looks at 5000 years of documented human history of interest rates, it would be of interest to you to note that not once have interest rates hit zero in the past before now. Interest rates were substantially positive even when the all-powerful Roman Empire was borrowing (almost 2000 years ago) at the peak of its influence. It is obvious from one look at such a long history of interest rates, that the current anomaly of zero/very low interest rates world over are in all probability not sustainable and in a decade or so looking forward the risk is substantially to the upside. Investors ignoring this obvious risk are bringing themselves closer, to future financial grief.

Are the current rates incorporated in valuation models by analyst? Some of  the gentlemen mentioned earlier in this article would have you believe that current low interest rates are not incorporated in  current price to earnings multiples by the market, insulting the intelligence of almost any analyst doing a fundamental valuation. In doing valuation of companies analyst perforce incorporate the risk free rate( generally the 10 year government security yield) in their cost of capital, which they use to discount cash flows to arrive at a valuation number. The cost of capital is updated for changes in rates as they happen. To state otherwise, reflects complete ignorance of the valuation process or some extraneous agenda, we can’t address

Do lower interest rates mean higher price to earnings? Let’s examine this central assertion of the above mentioned gentlemen. Let’s look at the most liquid market in bonds and equity in the world, the US (approx. 54% of the MSCI World Equity Index and the largest bond market by far), to give ourselves a good factual base. In April 2007, US 10 year GSec was at 4.63% and the US S&P 500 was at a PE of 17.48, several cuts in rates and three quantitative easing’s latter, we are at a US 10 year GSec yield of 1.60% and a US S&P PE of 25.08. The price to earnings went up, most likely responding more to the quantitative easing, rather than the interest rate cuts. When one examines the Japanese markets over several decades the evidence is even clearer, a fall in yields to zero there, was associated with a compression in price to earnings. In April 2007 the 10 year Japanese government bond (JGB) was at 1.63% and Nikkei 225 at 22.28 prices to earnings after a cut of 10 year JGB rates to minus 0.078%, the Nikkei 225 is today running at 17.90 time earnings. Looking at current negative interest rates in Japan, price to earnings should probably be near infinite as per our above gentlemen’s assertions. From the Japanese experience, it seems expansion in price to earnings has very little to do with fall in yield and much more to do with the amount of money pumped into the system by the central bank, by buying risk assets, hence pushing up their prices.  And yes growth is important, but as we can see from the European example, low or zero interest rates do not foster growth, its only growth of working population and increasing productivity per worker that generates growth.

To sum up, next time you find an investment expert giving you an opinion, be sure to ask what the basis of it is.

Zara Investment Advisory is long term positive on the Indian markets but believes price you buy at determines your returns. Hence, on a portfolio basis Zara’s focus is on managing risks and let returns take care of themselves as an outcome of an investment process involving margin of safety.

In your service
Dinesh da Costa, CFA                                                                                                    
Principal Officer
Investment adviser
Zara Investment Advisory
Mobile: 9822280576

Please note information given above is not a recommendation to invest, but an educational illustration.Any references to persons or places existing on date or before are coincidental , in an illustration meant purely for educational purposes.

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