It's time to focus on quality global businesses

Rallying markets have raised the valuations of many businesses, possibly to unsustainable levels. To my mind, it’s made one thing clearer than ever: investors need to bulk up on high quality Australian and global businesses, like CSL, Microsoft and Vivendi.

I recently talked about the gravitational force exerted on asset prices and values by interest rates. As interest rates fall so too does their gravitational pull on assets and values. I also reminded investors that while low interest rates are generally supportive for assets, they aren’t immune to setbacks. A rule for investing that should never be forgotten: the higher the price you pay, the lower your return.

With Professor Robert Shiller’s Cyclically Adjusted Price Earnings ratio at a near record high the implied return, for the next decade, from investing in the S&P500 index right now is very low. But a reasonable question might be what should that rate of return (also used as the ‘required return’ or ‘discount rate’ for valuation purposes) be?

To help answer that question and decide whether it is appropriate or even sustainable, we can adopt the work of NYU’s Stern School of Business professor Aswath Damodaran (whose books on valuation are required reading).

In conventional investment theory the required return is a function of the risk-free rate and the equity market risk premium (ERP). The ERP is a factor above the risk-free rate that compensates the investor for the added risk of not being in a risk-free investment. As I mentioned previously, as interest rates decline asset values and prices rise. So, it follows that as risk-free interest rates and ERPs decline, so do required returns and therefore equity valuations rise.

Many of the domestic investors who have captured the recent rally in the ASX200 have done so by willingly reducing their required returns. In turn this raises the ‘valuation’ of the equities they are examining and makes the current price look cheap compared to that valuation.

Should the risk-free rate be the interest rate on long-term government bonds?

Many investors believe that the risk-free rate should be the interest rate on long-term government bonds. But if current extremely low yields are unsustainable, and the resultant required returns plainly too low, the question to ask is whether investors should be chasing those yields down when adopting a required return for their valuation analysis.

When it comes to establishing the equity market risk premium, there is an equal amount of uncertainty about the right approach to adopt. It all led Warren Buffett many years ago to simply declare: ‘when a business manager approaches me for funds for a project, I simply charge them 15 per cent – that usually gets their attention’.

Instead of attempting to determine the correct discount rate, Damodaran suggests inverting the problem by determining what required return is being implied by the current market price of equities. He has done that each year since 1961, producing an estimate of the market-implied expected return of the US equity market. Using the 10-year U.S. government bond yield as a proxy for the risk-free rate, the market-implied ERP can be solved.

An average of 8%

Since the turn of the century, expected returns have averaged around 8 per cent. But because interest rates have declined considerably in that time, the equity market risk premium must have risen – remembering that the expected return is a function of the risk-free rate and the ERP. Indeed, the ERP appears to have risen from 2 or 3 per cent to 6 percent more recently. And when compared to corporate bonds, the spread is wider today than it has been since the 70s.

How is any of this helpful for an investor?

In simple terms, the ERP appears to be unusually and possibly unsustainably high. If the risk-free rate, as measured by bonds, stays low, then over time we could see the ERP come down. If that were to happen, then equities that appear expensive today might actually be cheap.

The conclusion from all of this however is that one should remain absolutely focused on quality. If you don’t own high quality businesses, then very little is going to save you when bad things happen to that business. Even a declining ERP is not going to help. Conversely, owning a high-quality domestic business, such as a Reece Plumbing, or an ARB or Cochlear or CSL, is going to reward you over the very long run regardless of interest rate ructions. The same might be said for high quality global companies such as Vivendi or Microsoft. However, if the ERP does fall and investors are more broadly willing to adopt lower required returns, these high-quality stocks could rally even further, and today’s extended prices might not seem that extended at all.

Roger Montgomery, Founder and Chief Investment Officer of Montgomery Investment Management