Overview
In this market insight we analyse:
The impact a 1.5% increase in the discount rate has on the valuation of a value stock and a growth stock.
The sensitivity of different equity markets to changes in interest rates. Two Asia markets – Taiwan and Singapore – are the least exposed to rising rates. In Europe, the UK is less sensitive to rising rates than other European markets, while American equities are the most leveraged to rising rates.
Whether value stocks can continue outperforming given their recent outperformance has exceeded the level implied by the increase in bond yields.
A Robust Valuation Framework
First, we need to determine the best way to value stocks.
Theoretically, stocks can be valued in the same way as bonds: by calculating the present value of future cashflows.
This is relatively straightforward for bonds, particularly for investment grade bonds where the cashflows are known with a high degree of certainty.
For equities, it’s far more complex. Several issues need to be addressed:
Cashflow measure
The theoretically pure approach to valuing stocks is to discount future dividends. This values stocks in the same way as bonds, with dividends representing the bond coupon payments. As stocks don’t have a maturity, a terminal value is typically incorporated into the model.
In practice, discounting dividends doesn’t work for companies which pay out a low proportion of their earnings as dividends (ie companies with a low payout ratio). Discounting future dividends tends to undervalue companies with a low payout ratio and overvalue companies with a high payout ratio. This issue has become more problematic due to companies prefer ring stock buybacks over dividend payments, particularly in the United States.
Terminal value
A terminal value is the net present value of all future cashflows assuming a constant growth rate. It is very sensitive to the growth rate and the discount rate with a slight change in either variable resulting in huge changes in the terminal value. And if the growth rate exceeds the discount rate, the terminal value is infinite.
Estimating growth
Estimating future growth is very difficult. As with any model, garbage in, garbage out applies. The fact discounted cashflow models are highly sensitive to growth assumptions exacerbates this problem.
Discount rate
The discount rate should be the risk-free rate (typically the rate of a relatively long duration sovereign bond) plus some additional return required to compensate for the risk of investing in the company. Based on finance theory or more specifically, the Capital Asset Pricing Model (CAPM), there is only one measure of risk that matters: the stock’s market beta. This is calculated by regressing historical stock returns against market returns (and is the slope of the line of best fit). This can be done over different time periods, using different data frequencies and using different market proxies. Herein lies one of the problems with beta: there is no universally accepted calculation methodology. Further, CAPM is based on a host of simplifying assumptions and the overall conclusion from this model – expected stock returns should solely be a function of beta – isn’t supported by empirical evidence.
We have developed a 3-stage discounted cashflow model which we believe addresses these issues. It doesn’t include a terminal value as this increases the model’s duration to a level where the NPV is overly sensitive to changes in the growth rate. We also have a robust algorithm for calculating growth based on the underlying trend in historic and forecast data. The cashflows are based on notional dividend payments whereby we adjust the payout ratio so that the model can be used to value low yielding and high yielding stocks.
The main output from the model is the IRR (ie the discount rate such that the sum of the discounted cashflows equals the current share price). This factor exhibits stronger predictive power than the other value factors in our factor suite based on a range of performance metrics in Asia, Europe, and the Americas.
Impact of Higher Bond Yields on Stock Valuations
Using our discounted cashflow valuation framework, higher bond yields will result in lower stock valuations due to an increase in the discount rate.
The impact on stock valuations, however, isn’t uniform. The impact is greatest for “long duration growth stocks”. These stocks have relatively low near term cashflows and relatively high distant cashflows.
To illustrate, consider two stocks in the fund’s Japanese stock universe:
MedPeer (6095 JP): a company which provides social network services for medical professionals.
Citizen Watch (7762 JP): a company primarily involved in the production and sale of watches.
The following table shows some commonly used valuation measures, as well as the growth rate based on our algorithm which measures the underlying growth rate based on historical and forecast data. This algorithm analyses cashflow and P&L data and rewards companies with consistent growth and penalizes companies with cyclical growth profiles.
Clearly MedPeer is expensive based on trailing, last reported and one year forward pro-rated financial data. However, it has an extremely strong growth profile.
At the other end of the spectrum, Citizen is cheap but has a weak growth profile.
Now for the key question: how much does an increase in the discount rate impact the valuations for the two stocks? To answer this question, we use our 3-stage discounted cashflow and adjust the discount rate from 7.5% to 9% (which is broadly in line with the increase in 10-year Treasury yields this year). Based on these assumptions, MedPeer’s stock valuation decreases by 20.1% while Citizen’s stock valuation decreases by 11.0%.
Another way of looking at price sensitivity to changes in discount rates is to calculate stock durations. Duration is a bond market concept and is used to measure of the sensitivity of bond prices to a change in interest rates. Macaulay duration estimates how many years it will take for an investor to be repaid the bond’s price by its total cash flows, while modified duration measures a bond’s price change given a 1% change in interest rates. Both measures are correlated.
Based on a 9% discount rate and the various assumptions incorporated into our discounted cashflow model, the Macaulay durations for MedPeer and Citizen are 17.7 years and 9.1 years, and the modified durations are 16.2 and 8.3. In other words, if the discount rate increases by 1% the theoretic share price of MedPeer will decline by 16.2% and the theoretical share price of Citizen will decline by 8.3%.
Aggregating the Data by Market
Aggregating the duration data by market tells an interesting story. We’ve calculated the average stock duration (for all stocks with analyst coverage) across the key Asian markets in our stock universe, as well as the United States and the largest European equity markets (Chart 1).
Chart 1: Average Macaulay duration
Source: OQFM
The lowest duration markets (which are less exposed to an increase in interest rates) are both in Asia: Taiwan and Singapore.
In Europe, the United Kingdom also has a relatively low average duration.
The United States has the highest average duration followed by Chinese ‘A’ shares. The monetary policy backdrop across the two markets, however, is vastly different. The Fed is likely to raise interest rates aggressively over the course of this year, while the PBOC has pledged to increase support for the Chinese economy and may cut rates. Hence, the sensitivity of high duration growth stocks to rising rates is currently less of an issue in China compared to the United States.
Will Value Continue Generating Alpha?
We start by examining the YTD average total return for the top and bottom quartile of Asian stocks in our universe ranked by duration. The average return for the low duration stocks (-6.3%) is better than the higher duration stocks (-13.3%). The outperformance of low duration stocks is no surprise given bond yields have increased significantly (eg 10-year Treasury yields have increased from 1.51% to 2.93% over the last 4 months).
Next, we compare this data to the average modified duration for the low duration cohort (10.9) and high duration cohort (15.1).
The main finding from these data is the relative YTD outperformance of low duration value stocks has been stronger than expected. It is also interesting to note that the overall decline in both cohorts has been less than expected given the change in the market discount rate implied by the increase in 10-year Treasury yields. One reason for this is that bond yields in many Asian markets haven’t increased as aggressively as they have in the United States, most notably in China and Japan.
While value has outpaced growth at a faster than expected rate over the last 4 months, this observation should be viewed in a wider context. Value significantly underperformed growth over the last 10 years which resulted in historically high value spreads in early 2021.
There are numerous ways to measure value spreads. Our preferred approach is to use book yield as the value measure and divide the book yield of cheap stocks (the top 30% sorted by book yield) by the book yield of expensive stocks (the bottom 30% divided by book yield). Excluding the most expensive stocks (defined as the bottom 10% of stocks based on book yield in each market) and market cap weighting the data across Asian markets, we can see that value spreads have converged but are still elevated (Chart 2).
Chart 2: Valuation spread in Asia
Source: OQFM, Factset
For most of the backtest period, the book yield of “cheap” Asian stocks was between three to five times higher than the book yield of “expensive” Asian stocks. Currently we are just above the upper bound of this range.
This implies that value stocks can continue generating alpha. This is more likely to occur if bond yields continue to normalize as central banks step up the fight against inflation.
The last point we want to make is we run a multi-factor investment process that feeds off a broad range of quant factors. Many factors are uncorrelated with value – for example, event factors – and some factors are negatively correlated with value – for example, momentum and growth factors.
Put differently, we’re not reliant on value outperforming to continue generating alpha.
We continue to believe that it’s a favorable market environment for our style of investing. As we have previously documented, we see strong similarities between the current market environment and the early years of this century. This is encouraging given the period from 2001 to 2007 was a characterized by extremely strong alpha generation.
We also believe our discretionary overlay will protect against downside risk and greatly reduce downside volatility. This has been our experience to-date with the fund’s downside volatility being extremely low relative to headline performance. It is also worth noting that the Fund’s biggest negative monthly gross return is only -1.8% (August 2020), a remarkable achievement given the strong fund performance and the different market regimes we’ve witnessed over the last couple of years.
Comments