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Interest Rate Fear, Macroeconomics
by Henry Lu
June, 2007
BlastInvest Model Portfolio Performance
Year to date, Blast
Investor Real-time Plus (BIRTP) model
portfolio was up 34.13%, out-performing S&P500 index by 26%.
Although BIRTP under-performed S&P500 index by nearly 10% in 2006,
for 1 and half year since Jan. 1 2006, BIRTP model portfolio was
up 30.6% while SP&500 was only up 22.8% during same time.
We expect that BIRTP performance relative to S&P500 index will be
uneven. Although there is no guarantee on future performance, BIRTP
performance goal was and always is to out-perform S&P500 index by
significant margin in the long run. We are confident that armed with
long term oriented value investing approach and focused style of stock
picking, BIRTP model portfolio will continue to out-perform S&P500
index by wide margin in the long run.
Recent Macro-economic Interest Rate Fears
Recent stock market movement has been volatile. The stock market
was quite bullish and was up a lot over last couple of months. Then
suddenly, the market sold off sharply over last 2 weeks out of fear of
interest rate rise and inflation risk. Finally over last several days,
the market rebounded violently again dismissing any fear of of interest
rise.
Interest Rate on Stock Market
One popular bullish argument recently is that current stock market is
quite cheap compared to current interest rate yield. The fed rate
has been up, but still at 5%, a low number historically. For most
healthy public companies in USA, it is quite easy to finance and to
obtain a bond at 7% rate or below. Low interest rate tends to support
high stock market valuation because cost of capital for companies is so
low that companies essentially can borrow cheap money and earn extra
profit by issuing bonds. Historically, Wall Street analysts tend to
value stocks by the projected future cash flow discounted by interest
rate. The lower the interest rate, the higher the stock price.
The current interest rate is so low that a bullish case can be made
that stock market index in average is cheap by a wide margin, possibly
at 20% to 30% compared to interest rate yield. Therefore, the stock
market index (SP500) will likely to go up a lot, possibly at double
digit rate over next several years.
We are not quite that bullish. We tend to believe that in stead of
stock market going up to match the low interest rate, the interest rate
is likely to go up gradually over next several years so that current
stock market is not that bargain. Inflation is up in USA,
inflation is up in China. In our opinion, it is highly unlikely that
interest rate will not go up in next several years although we are not
seeing any sign of hyperinflation in foreseeable future.
In conclusion, we believe stock market index will out-perform bonds by
couple of base
points over next several years. However, we suspect that any investors
expecting double digit annual return on S&P500 index over next
several years will be disappointed. We expect that overall market will
only deliver a mid single digit positive return over the long run.. In
that sense, we are not quite bullish as many bulls might want to be.
Cost of Capital Model on Interest Rate, Margin of Safety
The reason why so many Wall Street experts are so fearful of any slight
interest rate change is that they bet money on macro-economics while we
don't.
A slight interest rate change can dramatically change the valuation of
stocks if the valuation is based on popular model on cost of capital
calculation, which is linked to fed interest rate. Assuming the cost of
capital rate is same as interest rate, when interest rate go up, the
stock fair value drops. When interest rate goes down, the stock
fair value rises. When the macro-economic outlook on interest changed
from 5% to 6% or 8%, the stock valuation on this popular model can
change dramatically.
Warren Buffett once said in Berkshire Hathaway annual meeting that they
don't do cost of capital based valuation calculation. Buffett's
minimum discount rate is 10% regardless of how low the interest rate
will go down. Any risk adjusted valuation model at below 10% discount
rate does not have enough margin of safety.
At BIRTP, we take the same attitude on cost of capital calculation as
Buffett does. We don't believe the typical Wall Street analysts'
valuation calculation on cost of capital is that much useful. We
don't lower discount rate below 10% on valuing our picks regardless of
how low interest rate will go. In that sense, macroeconomic change of
5% or 6% of interest has no significant effect on our valuation
assessment. In fact, 10% is only our fair value calculation (the target
price), for most of our value picks, we require that the current
earning yield is above 10% so that our margin of safety on interest
rate is even higher than this 10% discount rate.
Conclusion on Interest Rate Fears
In conclusion, we don't care that much on short term interest rate
outlook. Our stock picking approach is not very sensitive to
minor interest rate change. Macroeconomics outlook also does not
affect our stock picking approach.
Discuss Value
Stock Picks in Value Investing Forum
Note:
Blast Investor Model Portfolio
Update
(as of 6/15/2007)
Model
Portfolio - Performance
|
BIRTP
|
S&P 500
|
Portfolio inception date
|
12/31/2003
|
12/31/2003
|
Portfolio inception value
|
$89,000
|
1114.10
|
Portfolio
12/31/05 value
|
$185,166.95
|
1248.29
|
| Portfolio
12/31/06 value |
$180,253.55
|
1418.30
|
| 2004
Performance |
59.53% |
8.78% |
2005
Performance
|
30.42%
|
3.00% |
2006
Performance
|
-2.65%
|
13.62%
|
2007
YTD Performance
|
34.13%
|
8.08%
|
Total
Return (Since Inception)
|
171.7%
|
37.6%
|
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