Last month, I wrote about my thoughts on the recent market rally and retail investors’ behavior during the rally.
Since then, I have observed that the sharp upward movement of stock index prices appears to be worldwide phenomenon. For Instance, China’s CSI 300 index has advanced 34% since the March low. South Korean and Russian markets also shot up during the past few months.
From my observations, all cases of this appear to be due at least in part to an increase in the number of investors in the markets. For instance, in South Korea, the number of active trading accounts rose to 31.25 million in April. That’s a shocking number given the population of South Korea is only 51.6 million.
Clearly, the ultra-low interest rate is having a big impact on who invests as much as how investors behave. Government interest rate cuts, while well-intended and undeniably beneficial in some respects, are having unintended consequences that may lead to inevitable pain for retail investors. They are encouraging individual investors to ignore the risks in order to find an alternative to the ever-decreasing yields of safer options. Meanwhile, government rescue of corporations is making them believe that the government can and will do whatever it can do to prevent the stock market from collapsing and companies from going bankrupt.
Warren Buffett (Trades, Portfolio) explains this topic very well:
“The pressure that is exerted by extremely low interest rates — short-term rates — on the value of everything else, it’s hard to overestimate that. I mean, the reason people have their money out at one-tenth of 1 percent is that they’re afraid of everything else. But as they’re being afraid of everything else abates, as it has over the last couple years, the pressure to push stock prices up, push real estate prices back up, it’s enormous.
And of course, that’s understood by people who have something to do with those matters. But I don’t think you should underestimate the degree to which the last year of stock prices has been a result of the agony that people are being put through that keep their money in short-term money instruments.
Unless they’re terrified of the world, they get pushed into other investments, and I think we’ve seen a lot of that, and we’ll see what happens when money rates do go up, if they do.”
As a value investor, the ultra-low interest rates are, quite frankly, agonizing. As Charlie Munger (Trades, Portfolio) said during the 2010 Berkshire Hathaway (BRK.A)(BRK.B) annual meeting:
“In some sense, the reality of our situation is almost amusingly depressing. Stocks are up because the return from loaning your money out at interest in a safe way is so lousy, and of course, one answer is that can’t last. In which case, stocks won’t be as pronounced a value, relatively speaking. And of course, if it does last, as it has in Japan, we won’t like that either because it will mean we’re mired in some horrible stagnation.”
The most important question is, what should value investors do in this ultra-low interest rate environment? Fortunately, we can draw some inspiration from famous value investors like Buffett, Munger and Li Lu.
The impact of interest rates depends on the company
During 1994’s annual meeting of Berkshire shareholders, Warren Buffett (Trades, Portfolio) said the following:
“Well, the value of every business, the value of a farm, the value of an apartment house, the value of any economic asset, is 100 percent sensitive to interest rates. And the higher interest rates are, the less that present value is going to be. So every business, by its nature, whether it’s Coca-Cola or Gillette or Wells Fargo, is in its intrinsic valuation, is a hundred percent sensitive to interest rates.
Now, the question as to whether a Wells Fargo or a Freddie Mac or whatever it may be, whether their business gets better or worse internally, as opposed to the valuation process, because of higher interest rates, that is not easy to figure. I mean, GEICO, if they write their insurance business at the same underwriting ratio — in other words they have the same loss and expense experience relative to premiums — they benefit by higher interest rates, obviously, over time, because they’re a float business, and the float is worth more to them.
Now, externally, getting back to the valuation part, the present value of those earnings also becomes less then. But the present value of Coke’s earnings becomes less in a higher interest rate environment. Wells Fargo, it’s — whether they earn more or less money under any given interest rate scenario is hard to figure. There may be one short-term effect and there may be another long- term effect. So I do not have to have a view on interest rates — and I don’t have a view on interest rates — to make a decision as to an insurance business, or a mortgage guarantor business, or a banking business, or something of the sort, relative to making a judgment about Coke or Gillette."
Don’t lower your threshhold
During the 1996 Berkshire annual meeting, Warren Buffett (Trades, Portfolio) suggested that if interest rates are very low, he and Munger might use higher discount rates. Below are his original words:
“We basically think in terms of the long-term government rate. And there may be times, when in a very — because we don’t think we’re any good at predicting interest rates, but probably in times of very — what would seem like very low rates — we might use a little higher rate.”
During the 2003 annual meeting, he added the following on the topic:
“We would use the same discount rate across all securities, because if you really knew the cash they were going to produce, you know, that would take care of it. We may be more conservative in estimating the returns of cash from some, but the discount rate we would use is a constant.
Now, in terms of where we commit, you know, we don’t want to use the fact that short-term rates are 1 1/4 percent to think that something that yields us 3 percent or 4 percent is a good deal. So we sort of have a minimum threshold in our mind about which we’re — below which — we’re unwilling to commit money. And we’re unwilling to commit it whether interest rates are 6 or 7 percent, or whether they’re 3 or 4 percent, or whether they’re, on a short-term basis, 1 percent.
We just — we don’t want to get hooked into long-term investments at low rates just because they’re a little bit better than short rates would be or low Government rates would be. So, we have minimum thresholds in our mind. I can’t tell you precisely what they are, but they’re a whole lot higher than present Government rates would be. And we want to be sure we’re getting an adequate return on capital. We don’t regard what we can get on short-term rates now as adequate, but we’ll still sit in — rather than bend a little bit and start settling for lower rates for 30 years because rates for 30 days are so low, we would rather just sit it out and wait a while.”
Require a higher margin of safety
In a recent interview, when asked about the impact of the current ultra-low interest rates, Li Lu said that the low interest rates certainly have an impact, but how big the impact is depends on whether this phenomenon can be sustained. He then added that ultra-low interest rates in major countries are rare in history. He is skeptical to the view that this new interest rate level can be used as justification for sustained high valuation levels.
Li believes that in the long run, if interest rates remain this low, there will be some negative consequences such as inflation and the potential damage to investors' confidence in the U.S. dollar. Therefore, Li thinks that if investors use the current interest rate as the "discount rate" in the investment model to value the company, they obviously do not think about the margin of safety very clearly.
The current low interest rate level, first of all, may be a very short-term and special abnormal phenomenon. Second, it is not a sign that the economy is getting better. In fact, it’s a sign that the economy is under extremely difficult conditions. So at this time, you should ask for a larger margin of safety, not a lower margin of safety, as practiced by many nowadays.
Read more here:
- A 3-Element Approach to Valuation
- Knowing What You Don't Know
- Notes From Li Lu's Recent Interview - Part III
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