In our previous article -“Does Frankfurt Have a Kremlin Branch” – we referenced a commonly used valuation metric, a company’s book value, as an illustration of market worries. However, within hours of publishing the piece I read a fascinating article which raised the prospect of analysts and corporate financiers ripping up the textbooks on traditional valuation models and metrics. The critical driver of this potential valuation anarchy is the incredibly low interest rate environment currently swaddling the financial markets.
Josh Brown at the Reformed Broker blog has written a thought-provoking article – “When everything that counts can’t be counted” – describing the incredible divergence in valuations between traditional asset heavy (Value) companies and the new asset-lite market darlings (Growth). The rapid expansion of new franchises challenging older incumbents has been fueled by an abundance of capital available at almost zero cost. When the term ZIRP – zero interest rate policies – was first coined post the GFC the commonly held view was that this was temporary. How wrong we were. Despite employment levels close to structural norms, moderate global growth and asset prices close to all time highs the central banks of the world balked at 2018 market volatility caused by the first steps in the unwind of Quantitative Easing(QE).
The Fed’s 2018 attempt to raise interest rates to normalised levels has been abandoned this year with monetary authorities around the world either cutting interest rates again or signalling the same. As someone who started his financial career in Japan I would have shared some concerns that Europe faced a multi-decade experience of almost stagnant growth and interest rates close to zero. However, I was not expecting to read in Brown’s piece a question raised by reknowned investment author William Bernstein. This big thinker confessed to wondering “What if the cost of capital never rises again?” This question has far-reaching implications for valuation techniques and unfortunately those who describe themselves as Value investors.
JP Morgan’s research team has written to clients telling them that there has never been a worse time to be a value investor – “value is currently trading at the biggest discount ever”. Value investing is a strategy whereby investors look for stocks that are underpriced relative to the fundamental analysis of the companies worth. One analytical metric is book value which captures things like plants, equipment and facilities. In a sense, one is trying to discover how much would it cost to replace those assets. It doesn’t capture things like brand, intellectual property and other intangibles. Therefore, if you can buy the cheapest stocks in the market at or below replacement value the odds are in your favour over the long term that this hidden value accumulated over the years will crystalise as a decent return on your investment. That strategy has worked for decades on any long term historic view of the markets…..until now. The story since 2010 has been very ugly for this strategy leading to massive underperformance vs growth stocks who don’t build factories but access almost-free capital to lease offices, develop IP, innovate and build user bases, brand and quasi-monopolies – think Uber, Netflix, Spotify, Amazon, AirBnB or PayPal. See the 9 year ratio chart of a value stock ETF(IVE) divided by the growth stock ETF (IVW) for a striking illustration of this painful period for value strategies:
This is not just a book value phenomenon. Results have been painfully similar for strategies utilising price-earnings ratios, cash flow multiples, dividend yields or a blend of them all. The value tortoise has been left behind the hare(or the hairy) strategies which ignore traditional valuations and now focus on the likes of market monopoly optionality, user base growth, recurring revenue, brand acceleration and mobile ubiquity. In a ZIRP future of unlimited access to super cheap capital, real assets of older franchises will be under constant threat from new players and possibly remain permanently undervalued.
Even a recession might not help as growth becomes scarce and attracts further capital relative to lower growth cyclical businesses. Clearly, over the years it has been a fool’s errand to forecast future market moves and in particular, interest rates which have been moving in only one direction for almost 40 years; US rates peaked at over 15% in 1981. So, if we are stuck in permanent ZIRP mode what can companies and investors do? Here are two possibilities:
- Investors: Start to factor in long term zero interest rates and begin to think about the risks of hoping for a different outcome. Indeed, even the value wizard, Warren Buffett, has started to buy Amazon.
- Companies: Ensure investors see you are making a digital transformation. WalMart, Disney and McDonalds have been successful in highlighting the intangibles/user multiples of their franchises and escaping “value trap” status.
The headline in this article asked a question. Unfortunately, there is no definitive answer but in an asset-lite world entrepreneurs/founders should be focusing on the following metrics when communicating with investors:
- Sales growth rate/momentum
- Incremental/marginal costs of producing additional unit of a good or service
- Growth of IP/engineering personnel cost vs growth of sales personnel cost. The latter needs to win that race.
- Recurring revenue(monthly, quarterly, annual)
- Growth in recurring revenue
- Lifetime value of customer – or user in today’s millenium vernacular. Customer is sooo yesterday!
Ideally, managements should create proprietary multiples and ratios to track these metrics. These will be the basis for valuation discussions and we will write additional articles on sample companies which are using these metrics most prominently in their investor communications. Sadly, for a cash flow returns evangelist like myself the absence of an actual cost of capital is making discounted cash flow models almost redundant! No doubt as soon I throw out my battered old HP12c calculator markets, interest rates and inflation may conspire to confound yet again. However, Japan is our most studied ZIRP lab rat so far and that experience suggests we have more than a few years left of virtual valuation.