Tag Archives: financial

Historical Rates Impact Common Stocks

Summary We think there is a recency bias surrounding interest rates. Historical rates are in the band between 3% and 6%. We believe rates will rise when there is a demand for credit, which can be a good thing for common stock owners. Time and coincidence often cloud our own perception. Consider interest rates. Baby Boomers and Generation Xers became adults (25 or older) between 1965 and 2005. During that period, these adults witnessed an aberration in the history of interest rates. They saw moments of monumental highs (20%) and levels consistently above historical norms. The chart below shows that long- and short-term interest rates in the United States have spent most of the last 400 years in a range between 3% and 6%. We contend that this deviation clouds the judgment and expectations of many of today’s investors. There are numerous implications for long-duration common stock owners arising from the examination of historical interest rates. Intrinsic Value Computations The father of value investing, Ben Graham, concluded through his years of research that 10-year corporate bonds averaged 4.4%. Therefore, in his revised intrinsic value equation, he used 4.4% as the numerator for adjusting intrinsic value based on interest rate fluctuations. This long-term interest rate chart supports the validity of his choice, and is right in the middle of the 3-6% historical range. One could argue that long-duration equity investors have been using discount rates in their intrinsic value calculations much higher than historical interest rates justify. This is likely due to the unusually high rates of the period between 1965 and 2005, a recency bias. Commitment of Capital to Bond Investments In 1980, the prime interest rate at the major banks was 20%. Long-term Treasuries peaked at 15% in early 1981. Inflation topped out in 1981 at 11%. Thirty-year fixed mortgages were issued as high as 17%. What people didn’t realize at the time was that they were living through a five-standard deviation event, according to history. Even if inflation had stayed at 11%, those interest rates offered investors very high inflation-adjusted returns. As the famous bond investor Bill Gross has argued, this laid the groundwork for more than 30 years of declining interest rates and a normalization back into the band between 3% and 6%. This has rewarded bond investors and got them addicted to an asset-allocation commitment based on lookback returns which are statistically unlikely. Interest rates are currently below the historical 3-6% range, and will likely rebound over the next 10 years into the historically normal band. We believe common stock buyers should include that likelihood in their stock selection methodology, whether in their intrinsic value calculations or in the effect that higher rates in the U.S. have on the U.S. dollar and overall economic growth in the country. We contend that the surprise in the U.S. will be how much stronger economic growth will be than what is expected. How else can rates go up, unless someone demands the capital via borrowing? Need for Solid Returns for Investors Owners of wealth in the form of liquid assets have an economic need in both low and high interest rate time periods. They need to earn a return above inflation to defend the purchasing power of their liquid asset pool. Ownership of long-duration common stocks has proven to be superior to that of other liquid assets over long time periods, except for the 10-year stretch from 1999 to 2008. As 10-year Treasuries fell to 1.6% in 2008 and stocks were liquidated in the financial crisis, two five-standard deviation events conspired to elevate bond investments in popularity and thrust bond portfolio managers into god-like status. We think a good rule of thumb is to avoid portfolio success stories created by five-standard deviation events. These only happen 2.5% of the time. Rather than being preoccupied with the consensus of investors, we believe building our portfolio around high-probability events is much more valuable to the long-term investor. Industries Benefited By Higher Rates in the 3-6% Range We have argued ad nauseam that common stock investors have two possibilities in front of them as it pertains to interest rates. If interest rates were to rise back into the 3-6% historically normal band, there must be forces which demand the money and industries which benefit from the forces that cause the rise in rates. If rates stay below the historical band, intrinsic value calculations using discount rates above the historical average will undervalue common stocks. Certain industries would welcome higher interest rates. Insurers must earn interest on collected premiums, banks would like to charge more for loans, and homebuilders would like to have so many customers for new homes that the resulting demand for money drives up interest rates. Consumer discretionary companies would love to see a level of prosperity which would drive retail sales and liberal advertising budgets. Drug and biotech companies would like everyone to be able to afford the fantastic new medicines they will introduce in the next 10 years. In summary, above-average returns don’t come along without taking risk. Investors have become very comfortable with today’s historically low interest rates, and fear continued poor economic growth rates. Equity portfolio managers use discount rates higher than today’s actual rates because of the abnormally high rates of the last 40 years. Lastly, the contrary long-duration common stock investor should be attracted to industries which benefit from the gravitation back into the historically normal returns from the bond market. The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.

VT: A Simple Choice For Getting Global Exposure

Summary The ETF has a good expense ratio, but investors can get a lower ratio by combining VEU and VOO. Investors need to remember the importance of international diversification even as domestic equity as thoroughly outperformed during the latest bull market. While I support having some international diversification, this fund offers almost 45% of the holdings as international equity. That is a bit too high for me. I see this fund as being maximized by investors that want to add it to their domestic allocations or investors with a long time horizon. The Vanguard Total World Stock ETF (NYSEARCA: VT ) is a great ETF for getting exposure across the world. The holdings are about 55% domestic and around 45% international. Expenses The expense ratio is a .17%. Vanguard regularly sets the bar for creating low fee investment vehicles for investors to gain solid diversification with low costs. My one concern in this area is that investors could use the Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ) for international allocations with a .14% expense ratio and the Vanguard S&P 500 ETF (NYSEARCA: VOO ) for domestic equity with an expense ratio of .05%. You could average those in any way you wanted since both parts offer lower expense ratios than the Vanguard Total World Stock ETF. Aside from that potential strategy to lower ratios, this is a very solid fund and a viable option for one stop shopping on equity exposure. Holdings I grabbed the following chart to demonstrate the weight of the top 10 holdings: For a total world ETF, I think investors had to expect Apple (NASDAQ: AAPL ) to be the top weight. The company is simply huge and their sheer size makes it necessary to give them a significant weight in any index attempting to replicate the entire world of equity securities. We have only stock that I think of as an international allocation within the top holdings. That, of course, is Nestle S.A. ( OTCPK:NSRGY ). As an international company, their sales are providing even further diversification as they rely on both developed and emerging markets for growth in sales. Nestle is the kind of dividend machine that SA Author Dividends Are Coming has suggested investors should buy and hold forever . The company is not always considered as a perennial dividend champion by domestic investors because their dividends appear to have suffered in a few years due to the currency exchange impacts. In their domestic currency, they are a great dividend growth company. Sectors (click to enlarge) If I was going to use a single ETF as the primary source of equity for my entire portfolio, I think I would prefer to see a slightly more defensive allocation strategy. For investors willing to go with the more aggressive allocations, such as having around 38% of the portfolio in the cyclical sectors, this is the kind of fund investors should consider for automatic investing. To avoid excess risk, that is a strategy for investors with a long enough time horizon to make up for losses as there should be both bull and bear markets over the next few decades. Region Domestic equities get a heavier weighting than international equities, but the international weights are fairly high. I must admit that as an investor I have a significant home country bias and I would not be comfortable with having even close to 45% of my equity in the form of international investments. For me the limit on international equity is closer to 30% and I prefer to run it closer to 15% to 20% of the total portfolio. I do feel compelled to point out that the allocation to emerging markets is within reason, so my concern would be coming from the strength of the allocations to developed markets. Generally developed markets are going to be less volatile than emerging markets but in this case the allocation to the developed markets is substantially larger and thus it is capable of generating more volatility at the portfolio level because of the weighting. Conclusion This is a solid ETF though the more attractive traders that don’t mind a more complex allocation may want to consider combining VEU and VOO if they really want to chase their expense ratios down to be as low as possible. In my opinion, this ETF should be combined with additional domestic allocations because the international allocations are simply a little too high for my taste. For investors that don’t mind the heavy international allocation and have a long time horizon to recover from any bear markets, this fund should be considered for regular purchasing.