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Fear of Inflation, Interest Rate, Earning Yield
by Henry Lu
June, 2006
Huge Sell Off, Fear of Rising Interest Rate
The recent sell off was sharp and ugly. The sell off was across the
board, and BIRTP* model portfolio suffered sharp losses. Should you be
worried?
Here we first talk about the reason and historical background of sell
off, and then we lay out our stock picking strategy in the sharp sell
off..
Why the Sharp Sell Off?
The sell off started out a month ago when the stock market was full of
rosy talk and bullish sentiment. The stock market in general assumed
that inflation of US economy was in check along with decent growth of
US economy, and that Federal Reserve (Fed) was
expected to end the interest rate raise soon.
All of sudden, the rosy perception changed. Fed Chairman
Ben
Bernanke hinted recently that he was still worried about the ever
increasing inflation risk. The Fed is likely to continue to raise
interest rate in the months ahead.
Chairman Bernanke has a point. All the relavent indicators have
been showing rising inflation. Prices of medical care and education are
rocketing at double digit rate per year. Average families are seeing
higher price in grocery stores, at gas pump, or at monthly utility
bill payment time. Commodity prices are rocketing so that average
companies are
seeing their raw material cost rising fast. High inflation is bad for
economy, therefore, one of main jobs of the Fed is to raise interest
rate to fight inflation. The higher the inflation, the higher the
interest rate. The higher the interest rate, the less pressure for
inflation to rise further more.
The problem is, fast rising interest rate is recipe for bad stock
market. Investors panicked, then the huge sell off across the board
without differentiation.
So why the rising interest rate is bad for stock market?
Cash Yield - the Ultimate Benchmark for Stock Market
Cash is important benchmark in our stock picking strategy. Cash
interest return is safe return. Any investor can deposit cash at banks
to earn interest, or buy government treasury bonds to obtain safe
return. Stock market is competing against banks and governments for
investors' money. Therefore, comparing attractiveness between cash and
stocks is very valid analysis.
As value investors we believe investment return on stocks mainly comes
from earning of a company, therefore we evaluate earning yield
(inverse of PE ratio)as if it is bond yield, and we can compare stock
earning yield to cash yield directly. In fact, if a company pays out
100% of its earning as dividend to its shareholders, buying the stock
is exactly like buying a bond and company's earning yield would
become just like a bond yield.
Hypothetical Case 1
Table 1 - Stock ABC verses
Cash,
as if 100% of earning is paid out as dividend to shareholders.
Ticker
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Cash in Bank
Account
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Stock ABC
|
PE
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20
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17
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Yield
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5%
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5.9%
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Annual Earning Growth
|
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3%
|
Risk
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no
|
yes
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Let's first look at hypothetical case 1 in table 1. Is stock ABC an
attractive investment? The answer is "maybe". The stock ABC is paying
5.9% yield, the earning is growing at 3%. The yield of stock ABC is
certainly better than cash. Cash is no-risk investment, stock is risky,
so higher rate on stocks is expected. (as we explain below, our answer
here is actually "no", but let's leave it "maybe" for now).
Hypothetical Case 2
Table 2 - Stock ABC verses
Cash,
as if 100% of earning is paid out as dividend to shareholders.
Ticker
|
Cash in Bank
Account
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Stock ABC
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PE
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11
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17
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Yield
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9%
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5.9%
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Annual Earning Growth
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3%
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Risk
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no
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yes
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Hypothetical case 2, same stock ABC, but different cash yield at 9%. Is
stock ABC an attractive investment? The answer is definitely NO.
If an investor can get safe return from bank at 9% yield,
why would he/she wants to invest into a risky stock ABC for getting
lower yield at 5.9% yield? Even considering the stock earning yield is
growing at 3% per year, 5.9% current earning yield is still too low.
As we can see above, the same stock ABC, the same PE, the same earning
yield, could change its attractiveness depending on the current and
expected future cash yield.
Margin of Safety - Significantly Higher Yield than Cash
When interest rate is rising, stock becomes less attractive.
Historically, if in average stock market yields at 4% above cash, it is
considered fairly priced and reasonably attractive. In other
word, in hypothetical case 1, stock ABC fair value is around 9% -
10% earning yield or PE= 10 to 11. Therefore, in our opinion,
stock ABC is not terribly expensive, but certainly is not very
attractive at PE of 17.
What I didn't tell you in hypothetical case 1 is, the current cash
yield is indeed around 5%, but the actual stock ABC is our S&P500
index.
Now with higher inflation talk and rising interest rate, it is not
surprising to see the recent huge sell off. The current margin of
safety for S&P500 index is not very thick.
The main difference between deep value approach verses other
"relative value approach" is the comparison to cash. Many analysts only
compare their stock picks to their peers in same sector, or just
S&P500 index. We not only compare picks against their peers, or
S&P500, we also compare our picks against cash.
No Bull on Stock Market, Not Bear on Economy
Having said above slightly bearish valuation assessment on stock market
in general, we believe the current market is great time for value
investors. Historically, value stocks
performed pretty well especially in bear
market environment, as evidenced on the stock market since 2000, and in
1970's.
We are not bear on US economy. US economy is still growing at positive
rate. Jobs are still abundant. Americans are still earning good salary
with good disposable income. This is not end of the world. Our opinion
has been consistent, the problem is the valuation of US stock market,
not the US economy.
The inflation risk is real, the
rising
interest
rate is real, but the same interest rate/inflation risk was there 3
months ago, or 1 year ago. This is not new problem.
Value Investing - Long Term Game
In the short
term, there is no direct consistent correlation between valuation and
stock price performance.
Stock market does behave irrationally from time to time. Many of ups or
downs are random without any fundamental
change. The market can penalize cheap stocks and expensive stocks
without any difference in short term. That is why a dirt cheap stock
can
continue to drop further and a
bubble stock can double or triple.
Value investing only works in the long run. That is why it is long term
oriented. Value investing is not a
short term
game.
Take CHK pick as example, BIRTP* picked CHK 2.5 years ago around $13,
within months, this pick lost 20% to around $11, big pain. But look at
current price, $29. The reason for all that change was fundamental
business growth. CHK PE was round 10 2 years ago and now the PE is
still less than 10. Over last 2 years, the earning per share doubled,
so did the stock
price. We never sold a share of CHK for more than 2 years.
This is the strategy we are executing on. We don't know the stock price
in next month or in several years exactly ahead. But we are banking on
cheap price of
less than PE of 10, and 20% or more earning growth from high earning
yield. As the business of CHK grows at current rate, the earning
per share will double in several years. Go figure,even if CHK will
trade at
same cheap PE of less than 10, the stock price would double in
several years.
We don't know how BIRTP picks would do exactly in future sell off or
bear market either. But we do know historically, bear market bottomed
when
average market PE was around 10. Many of our picks trade below PE of
10, or
below the average valuation in bear market. 1970's was bear market
decade, but 1970's was those years when value investing performed
superbly.
In the short term, cheap valuation does not mean fast buck, or quick
rise of stock price. But in the long run, value investing strategy does
work.
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