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Low Rate Beneficiaries in a Rising Environment & Path Ahead

GMO White Paper – For Whom the Bond Tolls: Low Rate Beneficiaries in a Rising Environment, April 2017

Bond surrogates: stocks with a high beta to bonds

  • US stocks whose returns are most sensitive to bonds have seen valuations climb dramatically since late 2008/early 2009
  • Bond surrogates are defined as top quartile of the market on trailing 1-year beta to 7- to 10-year US government bonds
    • This group trades at 20% premium to the market
  • The valuation between this group and those in the bottom quartile is near the widest it has been over the last 12 years
  • Composition of high beta to bonds cohort consists primarily of companies from REITs, Utilities, Telecommunication Services, and Consumer Staples (traditionally offer high yield and/or stable cash flows)
  • Given current elevated valuations for these stocks, however, their role as “safer” equities is suspect at best
    • Even if lower rates will last a while longer, this possibility may already be priced in
    • If one’s view is that longer-term yields are set to rise, then bond-like equities look like an explicit anti-value position

Further Reading: Beware of Bubble in “Safe” Stocks

Highly-levered stocks

  • Highly-levered non-financial companies represent another beneficiary of the low rate world
  • Historically, highly-levered companies trade at about a 14% discount to the market and that discount tends to widen leading into and during recessions as cash flows dry up, interest coverage wanes, and defaults rise
  • Immediately following the GFC, levered firms were valued in line with historical norms – today, they trade near parity with the market, offering no discount for their more precarious balance sheets
  • Median % of EBIT being diverted to interest payments for this cohort of companies has remained roughly constant since GFC, even as interest rates have fallen – this should be a clear warning sign to anyone familiar with the vicious dynamics of forced deleveraging

Financial engineers: swapping debt for equity

debt and equity issuance

  • Another group of beneficiary has been middle-of-the-road financial engineers
  • Faced with low growth prospects and friendly financing markets, companies have taken advantage of lower interest rates to raise large amounts of debt to buyback stocks
  • Not all companies are equally guilty – some firms are probably engaged in responsible balance sheet management, while many others are undoubtedly ensuring the future employment of bankruptcy lawyers
  • While low quality, junky companies have been responsible for a large portion of the debt issued, they are surprisingly not the worst offenders as far as debt for equity goes
    • Perhaps low quality firms were wise to refinance their debt at lower rates and extend their maturities, but balance sheets have expanded and they remain prone to economic downturns and rises in interest rates
  • Quality companies have also re-engineered their balance sheets using cheap debt and have been swapping debt for equity
    • For these firms, low interest rate environment presented a unique opportunity to effectively distribute offshore cash holdings in a tax-efficient manner
    • Quality as a group, and particularly select Technology, Health Care, and Consumer Staples companies, looks quite attractive relative to the broad US market on valuation grounds
  • “Middle quality” companies: firms that are neither quality nor junk – these firms have aggressively partaken in the debt for equity frenzy
    • Cumulative dollars spent on share buybacks since the GFC has been nearly matched by the total debt issuance
    • Unlike quality companies, most of these middling companies do not have the business models that can sustain dividends and buybacks while simultaneously servicing their newly higher debt loads once their interest payments increase or cash flows shrink
    • The worst offenders among this group span the entire spectrum from Consumer-oriented names to Industrials and Technology firms
    • Many members of this group stand a real risk of getting de-rated very quickly should shareholders awaken to the reality that significantly less of the pie will be left over for them after new legions of bondholders have taken their share

Growth stocks

  • In a slow growth world, investors have sought companies delivering high earnings growth
  • As interest rates have fallen, growth companies have benefited disproportionately from lower discount rates because most of their cash flows are weighted further in the future
    • In a world where near- and medium-term cash flows are hardly less valuable than cash today, the promise of even marginally higher cash flows in the distant future can look very attractive
  • Growth’s excess beta to bonds has increased substantially since GFC while value has moved from positive to quite negative
  • Given a 1% fall in the price of 7- to 10-year bonds, all else equal, we would expect value to outperform the market by 0.4% and growth to underperform the market by about 0.5%
    • On a relative basis, growth stocks stand to lose to both the market and to value stocks

Navigating the path ahead

  • Should note that many bond surrogates, highly-levered firms, and would-be financial engineers are to be found within the standard value indices
    • Investment approach that recognizes attractively-priced quality names, screens out companies that engage in questionable balance sheet management, and is attuned to the goings-on in the corporate bond markets will be required to safely navigate the equity markets as interest rates continue their ascent off of zero
  • Both Brexit and election of Trump have introduced a large amount of economic uncertainty into the investment equation
  • Traditional value investor’s admonishment that “the greatest sin is to overpay for assets” becomes ever more important as the future value of assets gets harder and harder to forecast
  • Applying a high discount rate to cash flows that will not occur until far in the future is a rational response to heightened economic and political uncertainty and would likely be kind to value investors and harmful to growth-oriented investment styles
  • It is worth recalling that the immediate response of the equity market to Brexit and the 2016 US election was to strongly favor value over growth
Image Source: GMO, Compustat, Worldscope, MSCI
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