Equity Duration & Inflation: Defining Equity Duration
This is Part I of a three-part series. Read Part II here and Part III here.
“Our willingness to wait reveals the value we place on the object we’re waiting for.” – Charles Stanley
There are three general scenarios in which stocks decline. Let’s look at them through the lens of the price-to-earnings (P/E) ratio.
- P-driven: The price investors are willing to pay for each dollar of corporate earnings. An example would be when a valuation bubble pops and investors come to their senses, or an external shock creates temporary panic.
- E-driven: Expectations for corporate earnings. To illustrate, a recession or cyclical downturn leads to temporarily lower earnings.
Stock prices fall in both scenarios, but the “fair value” of most businesses doesn’t change. Assuming no changes in a single company’s fundamental outlook, either scenario can present opportunities for long-term minded investors looking to capitalize on the market’s short-term myopia.
The third scenario, on the other hand, can have a far different result and remedy.
- P-and-E-driven: A stagflationary environment that reduces both earnings and the price investors are willing to pay for each dollar of those earnings.
Here, the fair value of most companies drops alongside the share price, as the terminal P/E – or the multiple investors expect to pay when the company reaches maturity – is also diminished due to persistently higher expected discount rates. Compared with the other two scenarios, these selloffs are more rational. What a prudent investor should do in this case is far less certain.
As we’ll see in Part III of this series on the Nifty Fifty stocks of the 1970s, it’s not until the market stops worrying about stagflation that P/E multiples and earnings can return to a more balanced state and great businesses once again get their due.
We believe we are in the third scenario today. To formulate a prudent response to a stagflation-worried market, we must first understand the role equity duration plays. Over the next three posts, we will explain ways in which investors can approach today’s market through the lens of equity duration.
Bird in hand
Imagine two bonds, both with a 5% coupon. Every other characteristic is the same, except one matures in five years and the other in 30 years.
Even though both bonds are paying $50 per year in interest, the 30-year bond is much more sensitive to changes in benchmark interest rates. This is because you won’t receive the bulk of the bond’s cash flows for over a decade.
“Long-duration” stocks are similarly expected to generate the bulk of their cash flow in the distant future. These are generally “growth” companies that are in the process of widening their economic moats.
By comparison, “short-duration” stocks are usually well-established companies that produce high levels of current cash flow.
Goldman Sachs tracks baskets of 50 stocks in the Russell 1000 Index with the longest and shortest implied equity durations. As this chart shows, it’s been a rough year for long-duration stocks.
Source: Goldman Sachs, as of 8/16/22
When the market panics, investors want cash now, not cash tomorrow. Makes sense. But how should investors consider equity duration when evaluating an investment?
Duration is an important term to understand when investing in bonds because it tells you how sensitive a bond’s price is to changes in benchmark interest rates. With bonds, you know exactly what the bond will pay in interest each period until maturity, so you can mathematically determine each bond’s sensitivity to interest rates. (Sean will talk more about “stocks as bonds” in Part II of this series.)
With equities, it’s more complicated. For one, we don’t know how much distributable cash flow a company will generate over the next five years and beyond. And unlike bonds, there is no maturity date on businesses.
Still, the comparison is apt because long-duration bonds and equities are more sensitive to interest rates and inflation. Long-duration equities can endure higher interest rates when it is accompanied by robust economic growth. The economic tailwind increases the chances that the business achieves its long-term objectives.
This year, however, stagflation worries are working against long-duration equities in two ways – higher interest rates and inflation paired with slower economic growth. This double whammy has called into question both long-duration companies’ abilities to meet distant objectives and what investors are willing to pay while they wait for those companies’ (increasingly uncertain) objectives to play out.
Future in focus
Let’s illustrate by looking at the annual free cash flow forecasts for two fictional companies – one long-duration and the other short-duration.
The long-duration company is not expected to generate free cash flow until year five and doesn’t match the cash flows of the short-duration company until year nine. By comparison, the short-duration company plods along, steadily growing its free cash flow.
Yet, assuming an 8.5% discount rate and a 5% terminal growth rate for both, the fair values are equivalent. *
Judging by the cadence of the cash flows, you can see why the long-duration company might sell off harder during a market panic. Based on the above assumptions, 94% of the long-duration company’s fair value depends on it reaching those 10-year targets. A whiff of worry about the company’s long-term cash flows and investors will sell first and ask questions later.
That said, even though the short-duration company is currently pumping out free cash and its future appears a lot more dependable, 72% of its fair value still depends on the company achieving the 10-year forecast.
But that’s just the recession risk part of the equation. As this chart shows, keeping the cash flow forecasts the same, the long-duration company’s fair value is more sensitive to changes in the discount rate.
But not by as much as you might think. The move from an 8% to 11% discount rate drops the long-duration stock’s fair value by 60% and the short-duration stock’s by 50%.
The reason both types of equities sell-off in stagflationary environments is that they are punished by all three of the scenarios we discussed earlier. The “P” in the P/E declines due to fear, the “E” declines due to the recession, and the terminal P/E declines due to expectations that higher interest rates and inflation persist well into the future. Long-duration stocks are more sensitive to these effects, but all equities are exposed to stagflation risks.
Either way, you’re always betting on long-term outcomes with equities. This is the risk of investing in equities versus bonds, where cash flows are pre-determined. We can be compensated for taking on that added risk if our forecasts prove accurate. As business analysts, we see this as job one.
Short duration isn’t low risk
Today, short-duration equities feel much safer and more prudent. Why take a chance that a company will deliver much higher cash flows in five to ten years when you could invest in a company with high cash flows right now?
To be sure, short-duration stocks carry their own set of risks. For one, robust levels of current free cash flow could suggest limited reinvestment opportunities. We’re wary of low-growth companies because it indicates that their relevance with customers has declined. We don’t want to own melting ice cubes, nor do most CEOs want to lead them. As such, there’s a pronounced risk of management making a big acquisition to kickstart growth or take another drastic measure.
Conversely, long-duration companies may not be as risky as their short-term cash flow profiles may seem, particularly if you believe the company’s aggressive investments are laying the foundation for an economic moat. As the graph below illustrates, Home Depot’s free cash flow was solidly negative for most of the 1990s while it was building its national store footprint. Eventually, those investments paid off.
Long-duration stocks don’t have to have negative current free cash flow, but they are more often reinvesting aggressively to scale their businesses.
Accuracy is everything
Because equity value depends on long-term forecasts proving accurate, investors need to build sufficient conviction in a company’s prospects. While you will inevitably modify your forecasts, the best any investor can do at a point in time is have confidence in their outlook, supported by a deep understanding of the business.
What does deep understanding look like? At a minimum, investors should understand and have an opinion on the following:
- Key performance indicators – Every company has a handful of metrics that explain its fundamental performance. Ask yourself, “If a company only reported a few data points each quarter, what would I want to know as a business owner?” For Chipotle, for example, what matters is same-store sales, store growth, and restaurant level-margins. Booking is about room nights, average revenue per unit (ARPU), and EBITDA margins. Make some assumptions around those metrics. If you lose confidence that the company can achieve your expectations for these long-term KPIs, it may be time to reconsider the investment.
- Opportunity – Does the company’s growth depend on a secular trend or operational execution? The former requires you to track the broader sector opportunity, and in the latter, management’s skill. It also helps to know if the company is led by a Visionary or an Optimizer.
- Intangibles – If the company ceased to exist tomorrow, who would miss it and why? If you can’t answer this question or it isn’t clear what makes the company special, you either have more work to do or the company isn’t differentiated enough in the first place.
In our portfolio, we have a mix of what would be labeled long- and short-duration equities. Our focus is on owning great businesses trading at attractive prices. Regardless of the cash flow patterns or prevailing interest rates, of utmost importance to us is building conviction and accurately forecasting the business’s performance.
Without a doubt, it is more challenging in the short-term to own long-duration equities during stagflation concerns. Assuming we are correct in our evaluations of those businesses, the bulk of our expected returns in those investments won’t likely come until stagflation worries have passed. This was the case with many Nifty Fifty stocks in the 1970s. Fortunately, we do not think we’re in for a repeat of the 1970s, as we’ll discuss in Part III.
* In theory, the long-duration company would have a higher discount rate, but not necessarily. As Charlie Munger put it, “I’ve never heard an intelligent discussion on cost of capital,” so I won’t belabor the point here.
- In Part II of this series, we will illustrate the dramatic impact on valuations that can occur with long-duration assets, even when they produce the cash flows that investors expected.
- In Part III of this series, we’ll explore the large decline in valuations of long-duration stocks that occurred in the early 1970s when inflation increased to historically abnormal levels. We lay out a framework for thinking about when today’s long-duration equities are likely to recover to more historically normal valuations.
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