This is Part II of a three-part series. Read Part I here and Part III here.

“Conceptually, if you think of what you’re doing when you’re buying an equity is you’re buying two cashflows: the cashflow given out as a dividend and the cashflow that is retained by management to invest on your behalf and that’s the wildcard.” -Donald Yacktman

Before he retired, former Morningstar Mutual Fund Manager of the Decade nominee, Donald Yacktman, used to give a presentation on stock picking that he called Viewing Stocks as Bonds. Many investors think of bonds as safe, low returning investments that produce cash while stocks are dots on your computer screen that bounce around and your job is to guess where they will bounce next. But Yacktman understood that, in fact, both stocks and bonds are securities that provide potential cash in the future in exchange for providing cash today.

Bonds are easy to think about this way. Today, if you give the US government $100,000 in cash, they will give you a newly issued 10-year treasury bond that will pay you 3% cash interest payments each year for 10 years and then return the $100,000 to you. This bond is considered an extremely safe investment because the US government is absolutely certain to make the interest payments on time and return your $100,000 to you in 10 years.

However, while this bond is considered safe, it could fall in value by 10% to 20% rather quickly. While there is near zero chance that the US government will not fulfill their side of the contract, other investors may decide that 3% is not a high enough return to interest them in buying your bond should you want to sell it. If other investors decide that they need to earn 5% to buy a 10-year treasury, they will only be willing to pay you $85,000 for the bond that you paid $100,000 for.

How could this be? Since the US government has not changed the terms of the bond in any way, what makes it worth 15% less? While nothing has change for you as the buyer of the bond or the US government as the seller of the bond, other investors have decided they want to earn a higher rate of return for choosing to own the bond in question. Since your $100,000 bond only pays $3,000 (3%) a year in interest, to earn a 5% rate of return other investors need to pay you $85,000 for your bond. By doing so, they will earn the same $3,000 in annual interest that you would get, and they will get $100,000 ten years from now for the bond they only paid $85,000 for. If you run the math, you will find that will yield the other investor a 5% annual return.

So, while the contractual cash flows of a 10-year treasury bond are as guaranteed as it gets in global financial markets, the actual value of a treasury bond is set by other investors who at any moment might radically change how much they want to get paid to own the bond.

Here’s a long-term chart of the yield to maturity of 10-year treasury bonds.

Over the last 60 years, investors have required a rate of return of anywhere between a 0.7% (in 2020) and 15.8% (in 1981) to own a 10-year treasury. This is despite the fact that at no point during that time period was there any doubt that the US government would indeed make good on contractual bond payments.

Let’s say you bought a 10-year treasury with a 0.7% yield, but when you turn around to sell it other investors wanted to earn a 15.8% rate of return. In this case, the bond you paid $100,000 for would be worth only $26,000. A 74% decline in value. If instead you bought a 10-year treasury with a 15.8% rate of return, and then sold it to an investor who only needed to earn 0.7%, the other investor would be willing to pay you $245,000 a 145% gain.

What this illustrates is that the value of a bond, even one guaranteed by the full faith and credit of the US government, is highly influenced by the opinions of other investors. These other investors may demand a higher or lower rate of return at any point in time for reasons that make sense or may not.

At the beginning of the year for instance, other investors only demanded a 1.5% return to own a 10-year treasury while today that has doubled to 3.0%. This change has knocked down the value of a newly issued 10-year treasury by 12%. Since a buyer of a 10-year treasury at the beginning of the year agreed to be paid just 1.5% a year, the 12% decline in value is equivalent to having lost 8 years of interest payments!

But here’s the thing. When you buy a 10-year treasury, you will end up earning whatever the initial rate of return was that you agreed to, so long as you hold it until the bond matures. Other investors’ opinions about the value of the bond and the rate for return they demand are irrelevant unless you decide you want to sell the bond prior to its maturity. But these other investors’ opinions can dramatically impact the current market value of the bond between when you purchase it and when it matures.

What Donald Yacktman was trying to communicate was that stocks behave the exact same way as bonds. The only difference is that bond interest payments and maturity values are guaranteed by contract (although of course, sometimes bond issuers default on the contract), while stocks, which offer a pro-rata claim on corporate cash flows, have uncertain future cash payments (dividends) and uncertain “maturity value” (i.e., the future value of the company when its growth phase is over, and the business model is fully mature).

In our very first blog post, we explored the concept of “intrinsic investing” and how we think about investing in much the same way as Donald Yacktman.

“If you forget about the stock market for a moment and just focus on businesses (after all, stocks are just a fractional share of a business), you’ll see that businesses have value to their owners that is independent of how valuable anyone else thinks they are. Businesses generate a stream of cash profits that have various degrees of volatility and risk. Clearly this cash is valuable to potential owners. But each potential owner will value that cash slightly differently.

In this way, the intrinsic value of a company is the price an investor would pay such that the cash return on their investment is satisfactory to them. That is, the cash return generated by the business, not the potential return generated by selling the business at some point in the future.”

Just like a bond’s rate of return if held to maturity is based on the contractual payments made by the bond issuer, not how valuable other investors might deem the bond between purchase and maturity, the same is true of stocks. But investors in stocks generate much higher returns than bond investors on average, because of the uncertainty of the future cash flows associated with a stock compared to a bond.

As we explained in our first post in this series, if you think of a stock in terms of a PE ratio, there are two typical ways that a stock declines that every investor is familiar with.

• The price can decline despite the earnings not declining. When this happens, it is a temporary phenomenon so long as the starting PE ratio was not above long-term fair value. But it is a more permanent event if the stock was overvalued to begin with.
• The earnings can decline, dragging the stock price along with it. When this happens, it is a temporary phenomenon so long as earnings recover (such as when the economy passes through a recession but then recovers, or a company experiences a period of weak results that they later recover from), but it is a more permanent event if the earnings were unsustainably elevated to begin with.

But then there is a third reason that is not as well understood, because it has been a historically rare event, which we believe is occurring now and having an outsized impact on long duration vs short duration companies.

• The fair value PE ratio of a stock can decline despite no meaningful change in the company’s earnings. This occurs when investors meaningfully increase the rate of return they require to feel fairly compensated for owning a stock. This happens when investors expect that inflation will run at historically high rates for a long period of time. When this occurs, investors require higher rates of forward equity returns (i.e., lower current PE ratios) so that they generate real returns that are consistent with the real returns they were accustomed to earning during periods of lower inflation.

The reason we use the bond examples in this post, is that they illustrate how even when there is no change at all in expected future cash flows, changes in investors’ required rates of return can have a huge impact on the value of the securities attached to those cash flows.

In our last post in this series, we will examine the 1970s and what that decade can teach us about the investment returns for long and short duration stocks during and after periods of elevated inflation.

Read Part III here.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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