(This is Part 4 of a four part series. Part 1, Part 2, and Part 3)

In the previous parts to this series we looked at the risks associated with low growth businesses, provided a case study of this risk manifesting itself in our portfolio, and showed that this risk is more urgent for the universe of companies that generate high returns on invested capital (the very types of businesses we focus on). In this final post in the series, we are going to explore what a New Normal (lower growth) economic environment means for valuation.

In our previous posts in this series, we assumed 5% as the baseline rate of growth that the average company will produce. This is in fact the historical average level of growth for both corporate revenue and GDP. When we looked at the impact of a slowing growth rate for a particular company, we were assuming that the slower growth rate applied only to the company in question and market/economic growth rates remained similar to the historical average.

But the New Normal thesis posits that economy wide growth has permanently slowed to a 4% average rate vs the 5% historical rate. We believe that the slower growth rate since the financial crisis may be a cyclical reaction to the debt crisis and the drags to growth may be fading with the return to Old Normal 5% growth that was seen in 2018 for the first time in a decade being a trend that will persist. But we fully recognize that in fact the New Normal thesis might be right, we might be at the tail end of economic growth and last year was more of a cyclical overshoot of the New Normal 4% average.

So given the risk of low growth that we’ve illustrated in this series, what is the risk of the whole economy slowing to 4%? Interestingly, it is less of a risk than you might think and in theory may lead to the market trading at higher valuations than it has historically.

Here’s the chart we showed earlier showing the impact to valuation of slower growth. A decline in the long term growth of a company from 5% to 4% results in a 20% decline in the free cash flow multiple the company’s stock should trade at.

But this chart assumes “all else equal”. What happens if the whole economy and corporate revenue growth slows from 5% to 4%? One thing that likely happens is interest rates decline. In general, the 10-year treasury yield has been about equal to nominal GDP growth rates. While this relationship is far from perfect, academic theory suggests that risk free interest rates should decline if growth is slower and in practice we see low interest rates around the world in low growth countries.

So in a world where economy wide growth declines, you get a negative impact to valuation as shown in the chart, but you also get a positive offset from lower interest rates which boosts the value of any business that can use debt financing.

Our math suggests that the forward 15.5x average PE ratio the US stock market has traded at is exactly what valuation math suggests it should trade at if you assume the following:

• 9% equity cost of capital (ie. the rate of return equity investors demand and the rate the market has actually returned).
• 7% debt cost of capital, which is what you would expect over the long term if you assume 5% risk free rates and a 2% credit spread (the historical spread) based on the BBB+/A- average credit rating of the S&P 500.
• 10% ROIC (the average historical rate)
• 30% effective taxes (the average historical rate)
• 5% growth

If you lower growth to 4%, the fair value PE for the market falls to 13.2. This 15% decline is less than the 20% decline in the chart above because in this instance we are talking about PE ratios rather than free cash flow yield. But the math is the same.

But if we assume this slow down is economy wide and so interest rates decline by 1% as well, then the fair value PE moves back up to 15.4. This looks like such a small change from the Old Normal PE level, it might be tempting to say slower growth doesn’t matter. But keep in mind that the benefits of debt financing vary between industries and companies. So a New Normal world would be one in which companies with high sustainable debt capacity would trade at higher than average multiples while debt free companies would trade at lower multiples. But the net effect on the market over all would be minimal.

But what about the equity cost of capital? Historically equity investors have demanded about 4% higher annual returns than debt investors in the same companies. In a low growth, low interest rate world, would equity investors still demand 9% annual returns or would be be OK with the same 4% “equity risk premium” over now lower bond yields and thus price stocks to generate 8% returns? If after lowering growth and interest costs, we also lower the equity cost of capital to 8%, the fair value PE shoots up to 19x.

Wait, how could low growth result in higher valuations? Most people are used to seeing high earnings multiples in the context of high growth companies. But a high multiple just means equity investment returns are going to be lower going forward than they would be under a lower multiple. And so to generate a lower rate of return on stocks (8% instead of 9%) you need a higher PE multiple.

In this chart, we summarize how changes to future growth and the cost of capital would impact the fair value of the market.

This isn’t just academic theory. Look at how Japan’s stock market over the last 20 years has seen 2% average growth in corporate revenue, low equity returns and low interest rates and traded at an average PE of 22x. So high earning multiples can be a result of high growth or high returns on invested capital, but it can also be a result of low cost of capital. The lower the return that debt and equity investors find acceptable, the more they will pay for a stock or bond.

 

Remember all the times you’ve heard people say that we live in a “low return world”? Well low returns come from high PE ratios, not low PE ratios (all else equal). So if you believe in a low growth, low return, New Normal world, than you should expect to see the stock market trade at higher than average PE ratios, not lower. This is true based on theory and it is what we see in practice.

So a low growth stock in an Old Normal growth world has material downside risk to valuation. But a low growth world, if that is indeed what the future will bring, is likely to result in similar or even higher than average valuation for the market overall.

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