The Price is Right: Part 1

If you’ve never spent a Sunday watching Antiques Roadshow on PBS, your life is missing something.  Especially the British version of Antiques Roadshow. The gist of the show is that a bunch of appraisers travel around and set up shop in various small towns here and there, and then people bring all of the stuff that has been lying around their attic for the last 25 years to see if it’s worth anything.  

It has even spawned its own hilarious meme.  At its core, Antiques Roadshow works for two reasons: one, it’s a big play-along treasure hunt so that everybody can be a couch Ray Dalio (fun fact: not only does Ray Dalio run the world's largest hedge fund, his submarine just found a $17B shipwreck treasure); two, it answers the age-old question of “that’s worth how much?” that has also fueled such long-running classics as The Price is Right and House Hunters.

In this month’s note, we are going to try and answer the question of “that’s worth how much?” with regard to stocks and bonds, a long running soap opera that’s on from 9:30am to 4pm daily (weekdays, anyway.  That aren’t federal holidays.)

TIME VALUE OF MONEY

Let’s start with a general concept we have discussed in these newsletters before - the time value of money.  This is important because it introduces two concepts that are central to any kind of valuation, stock market or otherwise.  One is the rate of return. The other is personal preference.

Say we were going to give you $100,000 in 10 years, guaranteed.  How much would you take right this second to give up the $100,000 in 10 years?  Would you take $30,000 right now, today, instead of $100,000 in 10 years? What about $50,000?  $80,000? How do you even start answering that question? (As an aside, this is exactly the business model of companies like JG Wentworth - you know, the one with the commercials of operatic bus riders).

Step one: objectively.  You can find an FDIC-insured online savings account that pays 1.5% interest right now.  If your money is just going to sit there at 1.5% then you would need to start with about $86,000 to get to $100,000 after 10 years.  If you were going to invest the money in the market and thought you could get 5% returns for 10 years, then you would only need about $61,000 to have the full $100,000 after 10 years.  The present day value of that future $100,000 is going to depend on what kind of returns you assume you’ll get in the interim.

Step two: subjectively.  This is where the art comes in to the valuation process.  Maybe you could get 5% returns in the market, but you personally don’t like that kind of risk.  Maybe you would just stick the money in a 10-year CD at the bank yielding 2.5%. If that’s the case, then you shouldn’t be willing to accept $61,000 today in exchange for $100,000 a decade from now, even though Russell Robertson, investor extraordinaire, might think that’s a perfectly fair valuation.  Or maybe you don't want $61,000 in cash, but would accept a signed, first-edition Zorg Man action figure that you think will be worth $100,000 (theoretically...once the ATI anime gets One Piece big).  What you value and how you value it differs completely from person to person, and that difference is, in fact, the underpinning of any kind of market anywhere in the world.

Step three: Clark Gable.  Sometimes life gets in the way of the purity of numbers and valuations can, frankly my dear, just not give a damn.

Same scenario as above, you’re just going to put the money into a 10-year CD.  Or were, until you out of nowhere got appendicitis and have a $20,000 hospital bill to pay.  Might you accept $61,000 today even though that’s technically, given your personal preferences, less than the value of $100,000 a decade from now in that scenario?  Yes, we daresay you might. (And that’s how JG Wentworth makes money, if you were curious).

BONDS

Okay, on to the real world!  We’ll start with bonds (fixed income), because they’re a little more straightforward than stocks.  When you buy a bond, you get paid interest for the life of the bond, and then it matures and you get the face value of the bond (ace value of a bond is considered “100”).  So if you get 100 at some point in the future, let’s say 10 years, and in the meantime collect interest payments, how much is that bond worth? 100? 102? 96? It’s the same basic question as the generic time value of money example, except you are getting paid in the interim.

Step 1: Objectively.  Let’s say the interest rate of the bond was equal to your rate of return: 2.5%.  In that case, the value of the bond today is the same as it is when it matures: 100.  If the interest rate of the bond is greater than your rate of return (say, 5%), then all else equal the bond will be worth more than 100 today (actually about 121 in that scenario).  If the interest rate of the bond is less than your rate of return (say, 1%), then all else equal the bond will also be worth less than 100 (actually about 87).

Step 2: Subjectively.  We say “all else equal” because in the time value of money example above, the $100,000 future payout was guaranteed.  In the bond world, payment at maturity is not guaranteed, because the company (or government) might default (go bankrupt).  That means you need to adjust valuations according to potential default risk. Default risk is largely based on quality of the company but should also take into account the term of the bond.  So if you have a 10-year US Government bond yielding 3% that is priced at 100, you would probably have a 10-year General Motors bond yielding 3% that is priced around 85, since General Motors has a greater risk of bankruptcy than the US Government.  In practice, it’s more likely that you would see a 10-year General Motors bond priced closer to 100 than 85, but for that to happen it would have to yield 5%, rather than the 3% of the government bond that is also priced at 100.  In a nutshell then, the longer the term of the bond and the riskier the issuing company, the higher the interest rate of the bond will have to be.

Step 3: Clark Gable.  Because sometimes central banks get in the way of the purity of valuations.  Typically, bonds are issued at a value of 100 and the interest rate of the bond varies based on riskiness of the issuing company as well as the term of the bond.  Because interest rates have been at or near zero for the last decade, any bond with any kind of yield whatsoever was attractive, valuations be damned. Companies were issuing bonds at 5% or 7% yields that had no business getting anybody ever to loan them money, but people have been desperate for yield.  The following are three real-life bond issuances that have taken place within just the last year:

Issue 1: $2.75 billion of 100-year bonds from Country A at 7.125%.

Country A has defaulted on its debt eight times since becoming independent - roughly once every 25 years for the last two centuries.  The most recent one occurred in 2001 and was the world’s largest default at the time (there was another technical one in 2014 during a spat with a predatory hedge fund, but we won’t be counting that one.  En unión y libertad!).  Country A received almost $10 billion in orders for this bond issuance…$10 billion wanted a piece of the action of a bond with probably a 100% chance of default before maturity.  For only 7% interest.

Issue 2: $700 million of 7-year bonds from Company W at 7.875%.

Company W is rated “below investment grade” by the ratings agencies, and it’s not particularly close to getting bumped up any time soon.  It has been in business for 8 years now, and is essentially a shared workspace provider for millennials. They are burning through cash, had earnings of negative $200 million last year, and have $18 billion in lease payments coming due in the next 5 years.  They initially wanted to sell $500 million of this bond, but there was so much demand in the marketplace (rumors have it that $2.5 billion wanted some of that action) they bumped it up to $700 million.  Oh, and the bonds are completely unsecured...you get nothing if the company can’t pay in 7 years.

Issue 3: $1.8 billion of 7-year bonds from Company T at 5.3%.

Company T is also rated “below investment grade”.  It has been in business for 15 years, and used to be the darling of investors everywhere.  It still is for many. The CEO is charismatic, compelling, and beyond doubt a visionary.  But the company itself has had lots of negative publicity, has consistently missed production targets for years now, is also burning through cash (almost literally with flamethrowers), and has only had two quarters of positive earnings (out of 60 quarters of operation).

Let’s put those newfound valuation skills to use and play a little game: imagine Wayne Brady calls you up to the stage on Let’s Make a Deal.  He presents you with three boxes, each of which represents one of those bond issuances above. You have the option to go back in time and purchase $10,000 of whichever issuance you want.  OR, you can take $5,000 and walk away. What do you do?

In the immortal words of Denzel Washington, "You must be outside your mind!".  Take the money and run.  None of those bonds are worth anywhere near what they are currently being valued at.  Which, when phrased like that is actually a massive contradiction...read that sentence as “none of those bonds are being valued accurately based on their fundamentals”.  The bond market has been completely Clark Gabled by years of artificially depressed yields and central bank liquidity that has essentially eliminated any kind of default risk in the pricing of bonds.

We have finally, just recently, began a long-overdue reduction in central bank intervention (for now, at least).  Part of that reduction means the increasing interest rates we've already seen, with a few more hikes coming in the future. Those hikes mean that the interest rate on already-issued bonds will be less than the required rate of return, and (remember from a few paragraphs ago) that means the value of the bonds will go down.  Interest rates up, price down. So you have rising default risk and rising interest rates, both serving to decrease the value of any bond, but especially the three basket cases listed above.  Bond repricing, anyone? It’s coming. 
Given the tooth length of this current note, we’ll stop here and pick up next week with The Misfits of stock valuation (another Clark Gable movie - look it up.)

And for the curious:

• Country A is Argentina.  That bond is trading around 87 after one year (you’re down 13% but have $1,425 in hand from interest payments).
  
• Company W is WeWork.  That bond is trading around 95 after one month (you’re already down 5% and there has been no interest payment yet).
  
• Company T is Tesla.  That bond is trading around 87 after nine months (you’re down 13% but have $265 in hand from interest payments).
  
• Take the cash and run - you have $5,000 in hand.