Should equity investors fear higher bond yields?

Andrew Mitchell, Ophir Asset Management

17 February 2021

Investors have been focused on the bond market in recent weeks because they have seen something unfamiliar - rising bond yields. In the first week of January, the US government 10-year bond yield (the rate of interest the US government borrows at) surpassed the psychological barrier of 1% for the first time since the Covid shock began.

Given lower bond yields have been used to justify higher share market valuations for much of the last decade, rising yields could pose a threat to equities.

Some seasoned and sceptical investors have been arguing for years that equity valuations have become dangerously dependent on the persistence of historically low bond yields.

While we don't believe the rise in bond yields is dangerous yet, or reflects the threat of a sharp acceleration in inflation, rising yields will likely be a headwind in gains for equities. And that means that if investors want to generate strong returns from equities in coming years, they will need to focus on stock picking skills.

Why bond yields have been heading higher

Expectations around economic growth and inflation have driven bond yields higher. The emergence of effective coronavirus vaccines has triggered optimism that the global economy will rebound powerfully in 2021. The US Senate elections in Georgia, which handed Democrats control, has also increased the Democrat's ability to drive through a reflationary economic agenda. Yet even as the pandemic recedes, it appears central banks are set to maintain policy rates at or near zero, further allowing inflation pressures to build. This comes as the US Fed, as well as the Australian RBA, want to now wait longer to see actual inflation heading sustainably higher, rather than expected inflation, before they start lifting interest rates.

How bond yields affect equity valuations

Bond yields are an important determinant of equity valuations. When bond yields go down, share market valuations tend to rise ... and as bond yields go up, share markets tend to falter.

The relationship may not exactly hold in the very short-run, but it becomes more clearly visible over longer time periods as can be seen in the figure below (cyclically-adjusted price-to-earnings ratio used a share market valuation measure).

There are three key and interrelated factors that link bond yields with equity valuations:

1. Firstly, bond yields drive the opportunity cost of equities. If, for example, the 10-year bond is yielding 5% per annum, then equities only become attractive if they can earn well above 5%. In fact, because equities are riskier than bonds, investors will demand a 'risk premium' to justify owning them. The long-term average risk premium on equities is 5%. So a 10% return - the 5% investors could get from bonds + the 5% risk premium -- will act as the opportunity cost for equity. Below a 10% return, it makes less sense for investors to hold equities because they are not being compensated for the additional risk. So as bond yields go up, the opportunity cost of investing in equities also goes up, and equities become less attractive.
2. Bond yields also impact the cost of capital in valuing equities. The yield on bonds is typically used as the risk-free rate when calculating this cost of capital. When bond yields go up, the cost of capital goes up. That means that future cash flows get discounted at a higher rate, meaning a $1 of cash flow received in the future from a company is worth less today. This compresses the valuations of these stocks.
3. Thirdly, bond yields impact financial costs for companies. When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing costs go higher, the risk of bankruptcy and default also increases, typically making highly leveraged companies vulnerable.

Good and bad market volatility

Although bond yields do impact share valuations, investors should be more worried about losses that result from a downward revision of a company's earnings potential, than losses caused by an increase in interest rates (all else equal).

The former suggests a market assessment that there is now a greater chance that the business will fail to deliver its expected earnings growth. While losses from increasing rates indicates the adjustment of the rate of discount, without a revision of market views on the company itself.

Indeed, to achieve long-term success, investors should distinguish between good and bad volatility. This is particularly invaluable for private investors who often regard any loss as bad news, when it may be an opportunity to lock in access to higher future income. For example, a move up in bond yields allows investors to buy and lock in future income at a lower cost. That's good news for anyone saving for a pension or an education endowment. For superannuation savings plans, it means that more future pension income can be bought with each new dollar of saving.

Should investors be worried?

The critical question is whether the current move up in bond yields goes beyond a healthy reflation that reflects the post-pandemic economy, and surges into inflation.

Presently markets are positioned for the former: that is, the economy will recover, but inflation will stay under control, and interest rates will remain low. 

Even under this scenario, investors should still factor in that equity valuations are likely to be pressured over coming years as interest rates trend higher. This means that strong equity returns will have to rely more on actively selecting the stocks that can generate sustainable earnings growth, and less on free kicks from falling bond yields and central banks cutting interest rates.

Or in other words, a greater proportion of returns are likely to come from stock picking skill rather than a rising tide lifting all boats (read: companies) in the market.

Why I don't think we're headed for a correction

Roger Montgomery, Montgomery Investment Management

February 2021

Over the last few months, increased risk-taking by investors has led to ballooning prices for loss-making businesses, IPOs in unprofitable firms, and speculative 'assets' like cryptocurrency. This is usually a signal that the market is too hot, and is due for a correction. Is the market at risk of an imminent collapse? 

There's no doubt pockets of exuberance exist. The recent activity in GameStop, the gold rush in electric vehicle and battery makers, and the surge in bitcoin more recently point to some seriously illogical, if not stupid, behaviour. Even in Australia convincing evidence of euphoria exists. The "buy now, pay later" sector here trades on a combined market capitalisation of $40 billion despite the requirement for dilutive future capital raisings to fund book growth and despite generating an annual loss of $82 million.

US-based billionaire futures trader Paul Tudor Jones, recently observed more US companies are currently priced at greater than 100 times earnings than ever before and the number exceeds, by half, those that traded at more than 100 times earnings during the dotcom bubble.

Bubbles deflating in isolation

Despite the clear evidence of bubbles in certain pockets of the market, however, I believe they can inflate and deflate in isolation. Indeed, we have already seen this occur. Last year, Hertz, Kodak and Nikola all rose between 600 and 1600 per cent in just a few months before crashing between 80 to 90 per cent. The bubbles inflated and burst and yet the broader market was uninterrupted. Similarly, the current bitcoin mania can crash without dragging the equity market down. It's done it before. It crashed - falling from nearly US$20,000 in 2018 to $4000 in 2019 - without any impact on the stock market.

Provided the entire market is not in a bubble, and the bubbling assets themselves are not held on the balance sheet of systemically important financial institutions, these bubbles can burst without wiping out the financial system or the returns for sensible investors who refrain from gambling.

What does a high PE ratio mean?

Speaking of the broader market, Robert Shiller's CAPE (Cyclically Adjusted Price Earnings) ratio for the S&P500 currently sits at its second-highest level in 150 years. The only time the ratio has been higher was during the tech bubble in 1999. Some commentators note that the elevated PE ratio is not only a sign of overvaluation but a warning of an imminent crash.  Robert Shiller himself, however, has noted the ratio is an unreliable tool for the prediction of crashes and prefers it to be used to estimate the average annual return for the forthcoming decade - something it is more reliable at predicting. Its lofty status suggests the next 10 years' average annual return for the S&P500 might be in the low single digits.

Of course, whether the market is overvalued or not depends on which measure you use. On standard PE metrics, the S&P 500 is trading at about 22 times predicted earnings for 2021, higher than the long-term average of about 16, but lower than the 30 it reached before the dotcom bubble turned into DotBomb.

25 per cent of the S&P500 is weighted to just six names

And before concluding the market is at risk of an imminent collapse, one must appreciate the fundamentals supporting the constituent companies, remembering 25 per cent of the S&P500 is weighted to just six names -- Facebook, Apple, Amazon, Microsoft, Google and Tesla - known as the FAAMGT stocks. The FAAMGTs are collectively worth more than $US8.1 trillion ($10.7 trillion), and account for almost one quarter of the $US33.3 trillion S&P 500.

For decades Warren Buffett espoused the importance of owning companies able to sustainably generate high rates of return on equity, noting that such performance could only be driven by the presence of a sustainable competitive advantage. Anyone who understands competitive advantages knows the most valuable is the ability to raise prices without a detrimental impact on unit sales volume. With the arguable exception of Tesla, in these monopoly companies inheres the most valuable of all competitive advantages.

Our own analysis reveals these companies to be incredible wealth creation machines. In almost every case their returns on equity are higher today than when they were smaller enterprises. The bigger they get the more profitable they become. Today's internet giants enjoy the benefit of infrastructure, such as computing power and storage, mobility networks and data speeds, that was inadequate back in 1999 when the first internet boom crashed. And there's a long runway for growth ahead.

Growth companies have simply seen more economic value accrue to them relative to more traditional companies with lower valuations, and unless antitrust legislation stops them, more value will accrue to their owners.

So, while the market does seem overvalued overall, there is merit in the idea that the companies driving the market higher have powerful economic moats and are themselves individually inexpensive -- excepting again perhaps Tesla!

Finally, as we discussed here, based on current bond rates (which of course could change - keep an eye out for a steepening yield curve) the Australian market appears to be fairly valued rather than expensive.

The market might be expensive but it is being driven by a serious weighting to companies with highly desirable and prized characteristics. Pockets of irrational exuberance do exist and they're easy to find but they can inflate and deflate without upsetting the rest of the market. And finally unless bond rates start to ratchet up, the market appears to be about fair value.

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Australian Fund Monitors' CEO, Chris Gosselin, speaks with Dean Fergie from Cyan Investment Management about the Cyan C3G Fund's recent and long-term performance.

Since inception in August 2014, the Fund has risen +16.52% p.a. versus the ASX200 Accumulation Index's annualised return over the same period of +6.81%. The Fund has also achieved a down-capture ratio (since inception) of 58.2%, indicating that, on average, it has significantly outperformed during the market's negative months.

Funds operated by this manager: Cyan C3G Fund

The AIM GHCF investor presentation briefly covers how the Fund performed in 2020; Charlie Aitken (CIO) and Etienne Vlok (PM) also discuss where they see opportunities in 2021 and how they are thinking about market risk. The stock discussion focuses on a relatively unknown Japanese vision sensor business that is incredibly high quality with a concrete runway for growth.

Summary
1:15 CY2020 performance summary
9:47 Top 10 holdings at 31 Jan 21
11:43 Sector allocation at 31 Jan 21
13:10 Geographic revenue allocation 31 Jan 21
14:24 Portfolio characteristics
16:10 Stock discussion: Keyence
27:20 Biggest risk for markets this year
36:54 Where we are seeing opportunities
39:11 Our focus: returns on capital
45:59 Our views on currencies
48:00 Are markets speculative at present?
50:28 What are the policy risks under a Biden administration?
53:49 Why doesn't the Fund invest in banks?

AIM Global High Conviction Fund

Bingo catches a bid. Who could be next?

Dominic Rose, Montgomery Investment Management

February 2021

Bingo Industries (ASX:BIN) confirmed in late January that it has received an unsolicited, indicative takeover proposal from a consortium led by private equity firm, CPE Capital (formerly known as CHAMP Private Equity), and including a Macquarie Infrastructure Fund (Macquarie Infrastructure & Real Assets, MIRA).

The cash offer price of $3.50 per share (representing a 28 per cent premium to the pre-bid closing share price) values the waste management company at $2.6 billion, equating to c.15x FY22 consensus EBITDA ($169 million) and c.10x BIN's medium-term earnings target ($250 million).

We are not surprised to see corporate interest in BIN's long-life, infrastructure assets which are strategically leveraged to attractive themes like recycling, population growth and government stimulus. In the low growth, low-return world we find ourselves in (where global interest rates are approaching zero!) large global investors with very long-term investment horizons and very low costs of capital are increasingly bidding up long-life, cash generative assets across sectors such as waste, utilities, infrastructure, telcos, and datacentres. Consequently, a competing bid for BIN can't be ruled out.

Founded in 2005, initially a family-owned skip bin business based in Western Sydney, BIN listed on the ASX in 2017 and has grown to become a vertically integrated waste management company with the largest network of recycling and resource recovery centres in NSW and VIC with 4.6 million tonnes per annum total network capacity.

Timing of the CPE Capital proposal appears somewhat opportunistic considering the bid comes ahead of an anticipated cyclical upswing and benefits from the optionality associated with developing the recycling ecology park at Eastern Creek. The domestic housing market is showing strong signs of recovery while Federal and state governments are looking to lift recycling rates in Australia, which remain well below other developed nations, and to stimulate the economy by fast-tracking the infrastructure project pipeline.

Further, a privatised Bingo could potentially be used by the Consortium as a platform to further consolidate the fragmented domestic waste management industry, particularly if the competition regulator forces various asset divestments should Veolia Environment (PA:VIE) be successful in its hostile takeover of French waste rival Suez (PA:SEVI).

The implied 10x valuation on BIN's medium-term EBITDA target compares to the 9.6x (pre-synergies) BIN paid for Dial-a-Dump in 2018 and the 10x (pre-synergies) Cleanaway (ASX:CWY) paid for ToxFree in 2017.

CPE Capital is no stranger to BIN having acquired the company's Banksmeadow facility in Sydney for $50 million in September 2019 after the ACCC forced the sale of the asset following BIN's $578 million Dial-a-Dump acquisition. We also note Macquarie's infrastructure investment arm, MIRA, is one of the biggest infrastructure investors in the world with more than US$130 billion in assets under management and waste management investments in North America and Europe.

The proposal is currently being considered by an Independent Board Committee and the company has granted the consortium due diligence. If the deal goes ahead, BIN's largest shareholder, the Tartak family, will potentially roll its stake into the bid vehicle, effectively allowing them to invest alongside the PE led consortium and share in the upside potential of the business. CEO Daniel Tartak holds 19.8 per cent of the company while Director Bill Malouf speaks for a further 12 per cent.

We expect opportunistic bids like this to become an emerging theme in Small Caps over the coming years. So the question then becomes who else could catch a bid?

There are plenty of companies within our investable universe with highly strategic, high quality, long-life assets which could catch the eye of large investors in a low-growth, low return world. Two that spring to mind (that we own of course!) are Macquarie Telecom Group (ASX:MAQ) and Uniti Group (ASX:UWL).

Datacentres and telco fibre are digital infrastructure for tomorrow's economy. Evidence of recent appetite for such assets includes Aussie Super's proposed acquisition of Infratil (NZX:IFT) (whose biggest asset is Canberra Datacentres, a close peer for MAQ) and Aware Super's bid for Opticomm (which UWL ultimately secured). We think both MAQ and UWL remain materially undervalued for their quality and growth characteristics...and given recent interest in the sector, perhaps private investors will see what we see?

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