“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects--if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up."[1]
- William McChesney Martin
Early in his career, a well-known behaviorist was watching students coming to class (many were late as usual) by taking the stairs at two – or even three – at a time without ever looking down. Mulling over a seminar he recently gave on “expecting the unexpected,” he decided to give in to his inner Sherlock Holmes[2] and asked maintenance to add a one-half-inch thick plank on to the top stair. After roughly three out of four students tripped and fell (these were days before OSHA and uncontrolled civil litigation!), he told the class how remarkably large a half inch can be when people aren’t looking at where they are going and complacent in their inner thinking. His message: Small things can lead to big events, especially when you aren’t aware of your surroundings.
A Valuation Dilemma
I bring this up because I was recently talking with my colleague John Dorfman at Dorfman Value Investments about an interesting problem facing those of us who use a discounted cash flow method for calculating intrinsic value. In my recent review of several portfolio holdings, each had several positive attributes: free cash flow growing, earnings increasing and management purchasing back shares. And yet, each company had seen my model’s estimated fair value for its stock drop over the past six-month period.
Like the students left rubbing their knees and scratching their heads, my immediate reaction was that there was a problem based on my calculations or process. I checked to see where I had misplaced a digit or entered an incorrect figure, but that wasn’t the case.
What was the half-inch plank that tripped up the valuations? It was that the 10-year Treasury note yield was rising, thereby decreasing intrinsic value more than the free cash flow growth was increasing it. Much as with our brilliant future scholars racing up the stairs, it’s amazing how much a difference a half point in the Federal Reserve discount rate can make in your valuations. This dilemma can frequently be seen near the end of bull markets and robust economies. As the Federal Reserve takes away Mr. Martin’s aforementioned punch bowl, increases in the federal funds rate can create enormous drag on your intrinsic valuation calculations.
How This Works: Calculating Intrinsic Value
Choosing a discount rate to use in valuing a stock’s future cash flow is a complex task. To do it, I use a seven-factor model, in which six of the factors are company-specific. I add together the six company-specific factors, which can result in a total as low as 5% or as high as 14%. After these company-specific criteria are scored, I then add in the current yield of the 10-year Treasury note. The total is the discount rate I will apply to future cash flow used to generate the company’s intrinsic value.
Company Attributes
Company Size: Range 1-3 (1 = largest 3 = smallest)
Financial Leverage: Range 1-3 (1 = none 3 = heavily leveraged)
Cyclicality: Range 0.5-1 (0.5 = none 1 = highly cyclical)
Management/Corporate Governance: Range 1-3 (1 = outstanding 3 = poor)
Economic Moat: Range 1-3 (1 = wide moat 3 = no moat)
Complexity: Range 0.5-1 (0.5 easy to Understand 1 = rocket science)
Market Attributes
10-Year Treasury Rate: (Insert Number)
Then sum the above numbers to get the discount rate
With this model, rising interest rates have a big impact on two groups of companies. The first is those at the higher end of the quality spectrum. Because their company-specific scores are low, increases in the 10-year Treasury rate can have a far greater impact than for a company with a poor score.
The second group is companies with high levels of debt on the balance sheet. As rates go up, this will disproportionately affect companies with higher debt servicing requirements. This second group hardly matters to me, since I invest almost exclusively in low-debt companies.
Let’s take a look at a current portfolio holding and a rising rate environment’s impact on its discount rate calculations and valuation.
A Working Example: Masimo
Masimo (MASI, Financial) is a mid-sized medical device company with no debt, little market cyclicality, outstanding corporate governance and a deep competitive moat. Its company specific scores on the discount rate calculation spreadsheet is 7.0%. It shows how a high-qualify company can see its fair value sliced badly as interest rates rise.
With the 10-year Treasury yielding 2.97% on June 12, the total discount rate would be 9.97% for Masimo. The 10-year rate makes up roughly 30% of Masimo’s total discount rate. It may not seem like much, but the impact after a 1, 2 or 3% increase in the 10-year rate can do truly horrible things to your calculated valuation.
At the current discount rate of 9.97%, I have Masimo valued at $105 per share. Raise the 10-year rate from 2.97% to 3.97% (increasing the total discount rate from 9.97% to 10.97%) and the valuation drops to $91 per share. Raise it to 4.97% and my valuation drops to $80 per share. With each full point increase in the 10-year Treasury rate, Masimo’s valuation drops by roughly 10-12%. It’s important to remember that this is for a company with zero debt. For companies with extremely high debt loads, valuation decreases can be far steeper.
To make up for this lost dollar valuation, Masimo would need to increase my estimated 8% growth in free cash flow over the next 10 years to nearly 11% annually – an increase of nearly 27%. These are numbers I find highly unlikely to occur. The drop in valuation can’t be made up by tweaking the growth numbers. I am left holding a company in the portfolio worth less today than it was six months ago. Realized loss or not, this is a painful exercise for any investment manager.
Conclusions
Rising interest rates as exhibited by the 10-year Treasury yield can have an enormous impact on corporate valuations. Improving fundamentals such as increased revenue, earnings, or free cash can sometimes be offset by even a small increase in interest rates. These same rates act as a gravitational pull on market valuations – and ultimately – on market returns.
While many argue whether the Fed’s decision to end quantitative easing and increase rates is too late or too early, investors should worry less about the punch bowl and more about market value and corporate valuations. Much as with those graduate students running up the stairs, it doesn’t take much of an increase to force investors and markets to stumble.
Disclosure: Masimo is held in several individual accounts managed by the author at Dorfman Value Investments LLC.
[1] This quote comes from a speech given on October 19, 1955, by William McChesney Martin, who served as Chairman of the Federal Reserve from 1951 through 1970, to the New York Group of the Investment Bankers Association of America. For those who are investing in a growing economy where the Fed is tightening rates and ending quantitative easing, there really isn’t a better read to influence your thinking.
[2] This is from the classic case of Holmes asking Dr. Watson how many stairs there were on the way up to their flat. When Dr. Watson did not know, Holmes’s retort was the classic “you see, but you do not observe.”
