In our view, all true investors are value investors. To be an investor, you must assess the intrinsic value of a business and compare that assessment to the price at which that investment can be purchased. Any person who buys an investment without first assessing the intrinsic value is a speculator, not an investor. In evaluating the intrinsic value of a company an investor must do two things: estimate the amount of cash a business will generate between now and judgement day; and determine the appropriate interest rate to discount the future cash flows to present value. At Magellan, we believe you can predict with more certainty the future cash flows for an outstanding business with entrenched competitive advantages than you can with a mediocre business. If we cannot reasonably predict the likely cash flows a business will generate over time, we will pass on the opportunity. You cannot properly compensate for a large error in the level of future cash flows by adopting a higher discount rate.
Given that the present value of any business is sensitive to the discount rate being used, we spend considerable time thinking about the level of future interest rates. Interest rates are the gravity of markets – low long-term interest rates support higher valuations while higher long-term interest rates suppress valuations. It is concerning that there is so much commentary opining on whether or not share markets are under- or overvalued without any discussion about the likely level of future interest rates. We can confidently predict that many stock markets are presently overvalued if future long-term interest rates are 5% or greater and also predict that they are attractively valued if long-term interest rates are 3% or less in the future.
For many years before the global financial crisis in 2008, it was reasonable to adopt a discount rate of about 9% to 10% based on a long-term interest rate of 5% and an equity-risk premium of about 4% to 5%. A proxy that investors have historically adopted for the interest rate within the discount rate (also known as the ‘risk-free’ rate) has been the yield on highly liquid long-term government bonds such as 10-year US Treasuries or 10-year German Bunds. Since the global financial crisis, greater uncertainty surrounds the discount rate an investor should adopt in assessing the intrinsic value of a business. Post 2008, the major central banks undertook extremely aggressive monetary policy – they reduced short-term interest rates to very low (and even negative) rates and purchased vast quantities of bonds by expanding their balance sheets (quantitative easing) – that has dramatically lowered, even distorted, long-term interest rates. This has made the prevailing yields of long-term US Treasuries and German Bunds unusually poor benchmarks for assessing the appropriate risk-free interest rate to use for long-term valuation purposes. We believe investors are, in aggregate, adopting risk-free interest rates at levels materially lower than prevailed prior to 2008 but higher than the current long-term yields on US Treasuries and German Bunds. We can’t say this for certain because the risk-free interest rate being used by investors in aggregate is not transparent. It is not available on Bloomberg or in a newspaper. In this regard, the uncertainty over the true risk-free rate created by the policies of the major central banks over the past 10 years has made the investment business more challenging.
Without a reliable and transparent proxy, an investor must now make a judgment call about the appropriate risk-free interest rate to use in assessing the intrinsic value of a business. This judgement is complex and requires an investor to assess the likely level of future economic growth and inflation in particular. Both of these factors will be determined by many factors including: changes in consumption and investment patterns as populations age; the potential for future improvements in labour productivity; the impact of technological improvements; the impact of increased government debt on future consumption and economic growth; the potential trend towards protectionism; the impact of income inequality on politics, policy and labour relations; and so on.
Our best judgment is that many economies are likely to enter a prolonged period of more modest economic growth and lower inflation than prevailed over the extended period prior to 2008. We have therefore adopted a lower long-term interest rate than we have used in the past to ensure consistency with these economic views. Notwithstanding that we have adopted a lower-than-historical interest rate in our valuation models, we caution that economic cycles exist over the short term and we could experience a spike in inflation that might cause a spike in long-term interest rates. If this happened it would be highly disruptive to markets.