One of the headlines that flashed on TV last week was how Elon Musk had surpassed Warren Buffett in net worth. Now both of these men to me are heroes of capitalism, entrepreneurs, and game-changers. I consume their products, and thank them both for making them available. But their styles and their companies could not be more different. The performance of the stock prices of TSLA and BRK in 2020 speaks volumes about the environment we have been forced to invest in. While Tesla stock is up 285% YTD, Berkshire stock (both the A and the B classes) is down almost 15% for the year. This is also representative of growth, e.g. the Nasdaq 100 up almost 25% for the year and the Russell 2000 down almost 12% for the year (Source: Bloomberg).
If Berkshire stock was a currency, we might want to know how many Berkshire B shares would it take to buy one Tesla share. At the beginning of this year the number was roughly 3. Today it would take 8 Berkshires to buy one Tesla share. So clearly something has devalued Berkshires vs. TeslasTSLA.
There is no question, as discussed in my previous posts (here and here) that Tesla makes incredible cars, and as per design, is rolling out models S, E, X, Y in, ahem, succession. Berkshire, on the other hand, does not really have a product that titillates the senses like a Model S, or the fantasy turned reality of a Cybertruck. Unless, of course, we think BNSF freight trains, the gecko of GEICO, Duracell batteries, or Fruit of The Loom underwear deserve to be called sexy too.
But there is something more important behind this severe relative under-performance of what is called “value” which is more macro-economic in nature and not entirely something that Musk or Buffett can take credit (or blame) for. It is the level of global yields and the lowering of rates by central banks as far as the eye can see. To quote John Kenneth Galbraith, “economists are most economical with ideas: they made the ones learned in graduate school last a lifetime”. Today, the ideas that economists are most attached to is that lowering yields is the only way to stimulate growth and inflation. My take is, yes, this is true, if we believe that growth and inflation are measurable using asset prices alone. And the effect of low yields is not only increasing asset prices in absolute terms, but also creating a monumental dislocation between value stocks and growth stocks. The relative value spread is all too rational given the yield environment we are in, and painful for anyone looking to stock investing as a reflection of the intrinsic value of owning businesses in real time. In the final analysis, this time will likely turn out to be no different than past times, but we simply don’t know when.
Let us dig deeper to understand the math of yields on valuation in the simplest terms when yields are zero or negative.
Suppose we had a choice between $1 next year or $1 thirty years from now. Which one should we choose? Of course, we can only answer this question if I also provided the level of yields which is used to discount the future value of the dollar. If the level of yields was 1%, then the value of a dollar receivable next year would be 99 cents today, whereas the dollar receivable thirty years from now would be 74 cents today.
On the other hand, if rates were minus half a percent (-0.5%), the dollar receivable next year would be worth just a little over a dollar today, but the dollar receivable in thirty years would be worth $1.16 today. In other words, when rates become negative, for the same cash-flow, you would prefer me to delay paying you! And as we know, rates are negative on over $20 trillion of bonds globally, though the longest bonds are still flirting with 0%.
In many countries, with out-of-control central banks throwing more gasoline of low rates and asset purchases at an inflation fire that refuses to burn, investors have gotten the message. It has become preferable, the lower yields go, to receive cash-flows later, rather than sooner. This increases demand for long duration assets, and what’s longer duration than a promise that pays way out into the infinite future? Of course, the European Central Bank (ECB), for one, fanatically believes that it should take rates even further negative in order to hit an objective that is as fleeting as the ability to achieve it. Santayana famously said that fanaticism consists of redoubling your effort when you’ve forgotten your aim. By creating a disincentive to consume and defer returns into the future, negative yields are magnifying the problems that they are trying to solve in the first place, so they are doing fanatically more of what is not working.
So what, you ask, should we do as investors?
Let us assume that everyone collectively decides that the delayed cash-flow is better than a cash-flow next year. In other words, in this world a bird in hand is worth less than two in the bush. No one should rationally want to invest in assets that have an immediate benefit, opting to get the same benefit later as long as yields stay low enough. Companies in this twilight zone world will decide to invest when, given the same prospect, the fruits of labor are delivered later. In this world, everyone is playing for moon-shots, which is why Tesla is so much more valuable than any other auto company in the world.
The existing disconnect between growth and value will correct itself in due course. Most likely it will happen if and when global yields start to rise again. But for yields to rise, we need to either see actual inflation in products that we consume routinely, or for the market to collectively realize that asset prices have gone high enough. Neither event will happen with a lot of warning. But since the Fed is explicitly supporting asset prices (see the June 10 Powell testimony, page 7, here, where the Fed chair’s Freudian slip about targeting asset prices is very revealing), it is unlikely that asset prices will be allowed to correct much until the Fed thinks it is safe to do so. So for now, the only risk many market participants see is inflation (excluding asset price inflation), and investors have to keep doing the uncomfortable; i.e. keep buying growth assets, with the hopes that they will be able to exit before we have a crash (good luck!).
Second, investors should realize that the growth vs. value disconnect is a mathematical mirage caused by low yields. In other words, investors betting on the mirage disappearing on the next bend in the road should prefer stocks that are paying cash dividends because they can always re-invest these dividends into growth stocks next quarter if the mirage for some reason re-appears. The best dividends are to be had in sectors that have been beaten down, such as energy.
Third, investors should realize that at some point asset price inflation will have to result in actual inflation. The exact mechanism by which this happens is hard to forecast. But one way this could happen is by the demand from rising asset prices outstripping supply of real stuff that needs to be consumed. When the economy re-opens, as it certainly will at some point, there will be fewer restaurant seats, fewer airline flights, and fewer movie tickets, all in the name of “the Coronavirus”. Cyclical sectors that will be able to raise prices in this environment will be the net beneficiaries. I have already had my own experience of trying to get an outdoor table at a restaurant with plenty of seating but no open seats due to social distancing guidelines. So much money for the consumer but no where to spend it, unless you are somehow willing to out-pay the next person!
For now, investors just need to compare today’s stock market growth giants with yesterday’s growth leaders to see the impact of the discounting effect from low yields in action. NVidiaNVDA is more valuable than IntelINTC, NetfliNFLXx is more valuable than Disney, PayPal is more valuable than Bank of AmericaBAC, and Salesforce is more valuable than OracleORCL (Source: Bloomberg). The first entries in each comparison pay almost no dividend, the second entries do. Dividends are so out of fashion.
For investors with a long term horizon who refuse to lend at negative yields, the conclusion is simple: buying growth stocks over value stocks today is a bet on global bond markets continuing to march toward lower and lower yields. To use a polite version of Joel Greenblatt’s quote once again, “it’s like running through an explosive factory with a lit match: you might survive, but it is still not a great idea to do so”.