Interest rates, it has been said, are financial gravity. When rates are high, stock prices should be lower, because they reduce the present value of the future cashflows equity investors lay claims to. The opposite is also true; when rates are low, stock prices should be higher.
In December, the market value of the Bloomberg Barclays Global Negative Yielding Debt Index rose to a record $18 trillion, eclipsing the previous peak of $17 trillion in August 2019.
It is not surprising, then, many investors seeking returns amongst this harsh environment conclude there is little alternative to equities. Unlike during the dotcom frenzy or the housing bubble in the run-up to the global financial crisis, the speculative excesses this has spawned aren't limited to one industry or sector. Instead, the mania is more subtle, and reminiscent of the Nifty Fifty era of the 1970s.
The Nifty Fifty were a group of premier blue-chip stocks that became institutional darlings in the 1960s; soared in the early 1970s; before plummeting back to earth in the bear market of 1973-74. Whilst there was no definitive list, everyone at the time knew which these stocks were because they tended to share certain common characteristics: a reputation for quality and reliability demonstrated by an ability to operate profitably in good and bad times, with proven growth records and continual dividend increases.
Five decades later, most people are still familiar with household names such as Disney, McDonald’s, Procter & Gamble, PepsiCo, Coca-Cola, Pfizer and Johnson and Johnson. These – and others – were regarded as ‘one decision’ stocks that could be bought and never sold, because their prospects were so bright and their price-to-earnings (P/E) ratios of 30, 40, or even 70x were more than justified.
In one sense, the buyers weren’t wrong: a hypothetical equally weighted portfolio would have outperformed over the next thirty years. Eventually, however, the business fundamentals did catch up with valuations. The difficulty for professional money managers was that over the intervening period they would have endured a savage relative drawdown lasting two decades.
Fast forward to today, and a new legion of the Nifty Fifty is brewing. As before, the is no defined list, but the hallmarks are established businesses with robust competitive advantages and records of profitable growth where the P/E ratios of their stocks have been kited higher. If you’re sceptical, try searching for the #neversell hashtag on social media.
Figure 1: UK #neversell portfolio
Source: Bloomberg as at November 12, 2020, annual reports. For informational purposes only; not a recommendation of securitie
A selection of UK-listed companies are shown in the Figure 1, but this phenomenon is also showing across Europe and in America. These, and similar stocks, have enriched a generation of clients invested in quality growth funds such that it is hard to fault their managers for continuing to own them.
Figure 2: Equal-weighted #neversell portfolio
Source: Bloomberg as at November 12, 2020. Past performance does not guarantee future results. Chart does not depict any Aviva product or strategy
We can only speculate as to why the Nifty Fifty has returned. Perhaps investors, starved of yield from fixed-income securities, are looking for growth-bond substitutes. Or there may be a cohort of investment professionals, who came of age during a period that saw strategies based on statistical cheapness underperform remorselessly, are sceptical of low P/E ratios and reassured by high multiples. Or perhaps the leading edge of market efficiency has moved beyond formulating medium-term earnings forecasts, superior to those of the average participant, and into qualitative debates that constitute the terminal value of discounted cashflows, where the bulk of value resides.
Whatever the reason, the arithmetic for future returns from #neversell stocks is unforgiving. The mathematically justified multiple for a stream of future cashflows is the inverse of the investor’s discount rate less the perpetual growth rate of those cashflows.
Figure 3: Valuation arithmetic, derived from the dividend discount model
Source: Giles Parkinson, Aviva Investors
Market historians have observed that equities have delivered an annualised return of around eight per cent.1 If we know the starting multiple and take eight per cent as our opportunity cost, then the growth rate implied by today’s valuation can be backed out. So, from a starting free cash flow yield of two per cent, to achieve an eight per cent return from the asset, those cashflows need to grow at six per cent per annum forever. But forever is a long time in a competitive capitalist economy with the ever-present risk of disruptive obsolescence. In general, the companies presented in the table have delivered organic revenue growth rates at or around this level in recent years. Whether they can do so indefinitely – which is what the current valuation of their stocks demands – remains to be seen.
Equities look cheap if long-term interest rates stay low for the next four or five years, but attractive relative valuations are not spread evenly throughout the market. Precisely what the #neversell stocks are priced for isn’t the point: for some, the hurdles to them achieving anything close to their historic returns may be insurmountable, and even beating an equivalent equity market hurdle rate could be a stretch. In light of this, investors may look elsewhere; in companies with positive free cashflow and durable competitive advantages, which are trading on more reasonable multiples for equally attractive growth prospects.
This article first appeared in Investment Week.