When it comes to investing it’s never different this time; nor, however, is it ever the same. This difficult-to-navigate paradox creates a scarcity of longevity. Today’s persistently low yield environment has upped the ante and put many marquis names out of business. To be fair, alpha’s been elusive of late. It’s not that anyone suddenly became dumb. Rather, traditional methodologies are less robust today. Perhaps adopting a commodity framework can help generate returns in these investment conditions.
Let’s face it, investment yields are scarce. Those on sovereign bonds evaporated. Corporate credit interest rates are numbingly low. Earnings yields on stocks are paltry (i.e. multiples are high). Real estate cap rates are tumbling. No matter what the cause—central banks, safe asset shortages, the proliferation of passive investing, a lack of growth, whatever—cash flows derived from invested principals are small. Unfortunately, this is the current state of the investment markets. It’s our job to play the hand.
Money Now for Money Later
Valuation lies at the heart of my investment framework … at least it did, historically. As Warren Buffett famously said, “Price is what you pay. Value is what you get.” This resonates with me; however, I’m currently rethinking my position. Price is easy to determine, just look at it. What about value?
Before answering this seemingly simple question, it’s helpful to clarify just what investing is all about. Making money, right? Well, one can make money in lots of ways. I can perform a service for my employer in exchange for a paycheck; I can bake some cookies and sell them on my corner; I can also buy a bond and earn its yield. In all cases I make money, yet in different ways. (Note, that’ll use money interchangeably with currency, despite a pet peeve).
In the first case (the job), I trade my time and labor for money. In the second (the baker), I also buy raw materials in order to produce higher value goods. In the investment case, however, I purchase an (assumed) income stream using money that I currently have in order to earn even more over the course of time; it’s money now for (more) money later. Thus, investing is the act of making money from money.
With a clear definition of investing in hand, we can get back to our question of valuation. Valuation is a way to assess the attractiveness of an investment. In other words, it’s a way to frame how much money we expect to make (or lose) in the future in return for our money today. More later for less now is the objective—risk aside.
Today, however, cash flow yields are low when compared to history. Thus, investing appears less attractive under a traditional valuation framework. Yet, the “show must go on”, especially for us professionals. We must find a way to grow our capital in spite of these challenges.
Herein lays the dilemma: What to do when one’s approach no longer applies? Abandoning discipline is simply not a satisfactory solution for serious investors. We all need investing principals to guide our actions. Luckily, my friend Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, offers some helpful advice.
In a recent client letter, Want notes that:
“When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities have minimal to no yield … , then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type trading philosophy to guide your portfolio operations – you need to focus more on capital/money flows and positioning in order to harvest the natural swings in market prices driven by the underlying behaviours of participants …”Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING
According to Want, traditional valuation-based frameworks are less efficacious in low yield environments. Rather, the supply and demand dynamics of capital flows matter most. I’m certainly sympathetic to that! However, I think this view can be harmonized with a valuation approach without overhauling one’s entire investment philosophy.
When everything is “commodity-like”, the final price dominates its return profile. Remember, the purpose of investing is to earn money, not to hold the underlying assets. Thus, as yields converge to zero (and below, absurd as it may be), positive returns increasingly require the selling at a higher price; or as Want puts it, to “harvest the natural swings in market prices.” In essence, all assets become “trading sardines.”
“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’”Seth Klarman, Margin of Safety via ValueWalk
Thus, as yields dissipate, all investment decisions converge to price speculation … even for bonds that can only return par. (Please see the Appendix at the end of the article for some illustrations.) However, valuation need not be cast aside whole cloth. Rather, it must be reframed to acknowledge that all the “value” lies in the asset’s terminal value, when it’s finally exchanged for cash—be that at maturity or an intermediate sales date.
I find Want’s framework of recasting financial assets as commodities to be clarifying. It helped me override my previously held notions of valuation and provided me with a more powerful framework with which to understand the current investment landscape.
The Commodity-like World
What might this commodity-like world look like? Well, perhaps more commoditized (pun intended). Want continues:
“… Such swings won’t always make sense to a traditional analysis paradigm, it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of inventories’ that you may or may not wish to hold at different times depending upon how capital is behaving, where the money is flowing (& why), and how participants are positioned. A more detached and objective approach to markets will be even more valuable than usual.”Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING
In other words, as differentiations of cash flows diminish, investment decisions increasingly shift from allocation within asset classes to allocation among asset classes. Thus, the importance of (tactical) asset allocation increases in Want’s framework.
I can see other investment implications of a more commodity-like world. Perhaps:
- Speculation in bonds increases and investment horizons shorten as investors take a more total rate of return approach in light of falling yields; volatilities could rise
- Equity investment time horizons extend, as higher multiples force investors to look further into the future for required growth to materialize; volatilities could fall
- Commodities appear more attractive as storage costs become less of a relative disadvantage in a world where bonds don negative yields
- Correlations converge as interest rate sensitivities increase
- Security selection’s role in portfolio construction shifts to risk management as the risk of loss dominates return profiles
- Or, I’m wrong about all of the above!
Unfortunately, we’re short on historical precedents for the current paradigm. Hence, we can only guess what impacts might materialize. However, I suspect that focusing on capital flows as Want suggests is a useful framework.
Reframing for the New Paradigm
It’s an understatement to call these challenging times for active management. Many traditional investment frameworks simply don’t work as well. Is it truly different this time?
Rather than abandon valuation in my framework, I’m reframing it. Conceptualizing “’everything’ [as] commodity-like” helps. We must speculate on all assets, plain and simple, looking to terminal values for returns. While my acceptance has been slow, commoditizing my investment framework has brought some clarity to these confounding times.
Appendix: Speculation Rises as Yields Fall
In this section I show what happens to hypothetical bond returns (using IRR) when coupons fall, maturities shorten, and when a sale occurs at a higher price prior to maturity. Note that in all cases the value shifts more towards the final payment. Thus, the incentive for speculation rises as yields fall. Assume all values are in U.S. dollars and undiscounted for simplicity. This exercise is for illustration purposes only.
Example: Initial Bond
Below is the payment stream for a hypothetical bond that matures at par in 5 years with a 10% coupon.
Note that the holder receives $150 in total payments. The final payment ($110) accounts for 73% of all value received.
Example: Falling Coupon
Here, I illustrate the payments for the same hypothetical bond but with a lower coupon of 5%.
Note that only $125 is received—due to the lower interest rate—and that the final payment ($105) accounts for a greater percentage (84%) of the total value.
Example: Shortened Maturity
Next, I show the payments for our 5% hypothetical bond but with a 3 year maturity instead of 5.
Here, only $115 is received due to 2 fewer years of coupon payments, though the IRR remains constant. As a result, the final payment occurs in year 3. It also accounts for 91% of the of the total value received.
Example: Pre-maturity Sale
In this last example, I illustrate what happens to the 5% hypothetical bond with a 5 year maturity when sold at a higher price ($105) prior to maturity (shown year 3).
There are a couple of interesting points to note. Since it was sold for $5 more than the maturity value (par), our total payments amount to $120. While this is $5 less than had it been held to maturity, the IRR increases to 7% (from 5%). The final payment now accounts for 92% of the total value received—the highest percentage of all our examples.
Note that the pre-maturity sale example had the highest return for the hypothetical, 5%-coupon bond. The sale price also dominated the return profile, illustrating how the bond became a more effective total rate of return instrument, ripe for speculation.
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