This guest post covering Jeremy Grantham's thoughts on the yield curve and how net nets can help investors weather difficult markets was written by guest contributor Xavier Hill and may or may not reflect the views of anybody else at Broken Leg Investing. Article image: Balint Földesi
While Jeremy Grantham would disagree, arguably the single best predictor of an impending recession is when the yield curve inverts. It is close to inverting right now. Yet Jeremy Grantham, a value investing legend, disagrees. Who is right and should deep value investors be worried?
Jeremy Grantham, What's A Yield Curve?
The size of the world’s stock markets is a mere pimple compared to the size of the world’s bond markets. This means that changes in the bond market have even greater consequences to the world economy than changes to the stock market. The largest bell weather of the world’s bond market is the US government bond market.
You can buy $US debt on all manner of terms but, as a rule, the longer the maturity date of the debt instrument the higher the interest payment (coupon) the market will require because nobody knows the future. Say you buy a US 30 year treasury at 5.00% coupon and in 10 years time interest rates rise to 10% you will be losing 5% of your money in real terms every year from year 10 onwards. Ouch. However, if you buy a 2 year treasury at, say, a 4.00% coupon rate and interest rates spike to 10% in the second year of the bond, you lose 6% in real terms but only for one year.
This relationship between the coupon rate and bond maturity is known as the yield curve. Here’s what a typical yield curve for US bonds looked like in February 2006:
US Yield Curve, 2006 (Source: Wikipedia)
You can buy 1 month all the way to 30 year US bonds but the relationship remains the same. The shorter term of the debt, the lower the risk and therefore the lower the yield.
Why Everybody But Jeremy Grantham Is Worried About The Yield Curve
As I write this, the yield curve is nearly flat and people are becoming worried. For example since January 2017 the difference between 2 year and 10 year Treasury yields has collapsed from 128 basis points to 57 basis points and is now the lowest it has been since the ‘08 recession.
You can see the changes in the yield curve over the past year below.
2017 US Yield Curve (Source: Bondsupermarket)
There are now economists everywhere predicting that yields will invert sometime next year. An inverted yield curve means investors are prepared to receive a lower yield on longer maturing debt than shorter maturing debt. This means investors believe interest rates and inflation are going to remain low or fall well into the future.
In a seminal 2004 paper on the subject, Professor Leland B. Yeager et al at Auburn University, in simple terms, found that Inverted yield curves only occur in an environment of cheap money where debt is easily accessible. These borrowed funds are often poorly invested and this inevitably leads to a crash. During periods of an inverted yield curve, the forces of inflation (due to the cheap money) and deflation (due to a poor economy) are fighting against each other, though deflation inevitably wins in the form of a recession.
In fact, inverted yield curves have occurred on only eight occasions since 1958 but, on 7 of these 8 occasions, a recession has occurred within 2 years.
You can see the phenomenon in the figure below:
Historic Inverted Yield Curves and Recessions (Source: Mises.org)
The correlation between inverted yield curves, recessions and therefore stock prices is clear and the causation (too much debt available that is poorly invested) is equally clear. It is a metric the market keeps a close eye on, yet I am not worried.
Jeremy Grantham Thinks You Should Ignore This Mega Trend
In his latest quarterly newsletter value investing legend Jeremy Grantham provides a compelling argument that the stock market is not headed for a crash and that bond yields can still decline further. Jeremy Granthams’ model considers US stock data back to 1925 the p/e (price to earning) ratios, inflation, profit margins of US stocks since 1925, and, to a lesser extent, stability of GDP growth (note not actual GDP growth). The analysis has been a big contributor to Grantham’s current thoughts on the market. Whereas in 2015 Jeremy Grantham was publicly stating that stocks were overpriced, his analysis justifies why stocks are at their current heights and more importantly why they are unlikely to fall.
As Jeremy Gratham states...
“Whether sensibly or not, investors love high margins and like stable growth even if it’s modest, and hate inflation. They felt this way from 1925 to 1997 and they felt exactly the same way in our new era of 1997 to 2017. So, behaviorally it is absolutely not a new era.”
This has large implications for investors as investors require higher earnings (and therefore lower p/e) in higher inflation environments. You can see the model’s correlation below. Note its predictive powers with the exception of the internet bubble of the late 1990’s.
GMO's Revamped Behavioural Model (Source: GMO)
Stocks have always been viewed as being an inflation hedge and, in many ways, they are unlike a bond. A company can pass additional costs onto consumers, yet as Jeremy Grantham and Nobel prize winning economist Franco Modigliani have discovered “...in real life, when inflation first appears or accelerates, there is an immediate, coincident negative effect on P/E multiples.”
Jeremy Grantham’s refining of the model has seen him overturn his bearish calls from last year and is now firmly a bull.
So we have effectively two major forces at work right now. One is that cheap money will cause a whole lot of mal investment which will see stocks crash when the debt cannot be repaid. This is what history has nearly always shown since 1958 when the yield curve inverts. The other force is that interest rates are low, inflation is low and therefore the market will go higher as stocks are still attractive relative to bonds.
Weathering Jeremy Grantham's Perfect Storm With Net Nets
It is in these competing forces that net net stocks stand out on their own. Net net stocks often do not enjoy strong profit margins (in fact the best are often losing money) and can rarely claim having experienced stable growth in the recent past.
On the surface net nets look horrible but they straddle these competing forces nicely. Net net stocks come with large inflation protections built in. Through buying a stock below NCAV you own inventories which are typically good hedges in an inflationary environment, you own cash which can be put to use by management within the business, and you own receivables, all bought below fair value if you were to liquidate the business. On top of these, you are getting non current assets such as property plant and equipment for free. While these assets do not always perform great in an inflationary environment, they do provide further protection.
Further to this, in an inflationary environment, net net companies can look to lift their profit margins -- a major positive factor. Since net nets typically have small profit margins, a small increase in profitability leads to a disproportionately large percentage increase in earnings growth, pushing the stock higher. It often has a dramatic effect on the value of the business in the market. While a growth stock may enjoy a 70% margin, a small increase in profitability also means a small percentage growth in profit. An increase to a 75% margin produces a relatively tiny increase in profit of just 7%, for example. Compare this with a net net with a margin of 1% that suddenly rises to 2% -- a 100% increase in profit and possible doubling for the stock! Luckily, drops in profitability from 1% to 0% rarely have the same effect on the downside since terrible performance is already priced in.
“Rule one never lose money. Rule two, don’t forget rule one.”
- Warren Buffett
This ability to outperform in inflationary environments which are followed by a recession is a major reason why net net strategies are so effective.
If the yield curve thesis, which is being hotly talked about by all manner of pundits right now, is correct, we are headed for recession and a stock market correction. Net net stocks have some of their best periods of outperformance in down markets relative the index, so net net stock holders are likely well protected in this event.
If Jeremy Grantham’s model continues to hold, with inflation remaining low and p/e ratios continue to increase, then net net stocks are again in a good position to profit. If your net net stocks are well selected according to Core7 principles, they are likely to turn around for a host of reasons, including mean reversion. As net nets typically have low margins and high p/es, as growth stocks become more expensive, net net stocks appear more attractive.
What I like most about net net stocks, or Ultra and Negative Enterprise Value stocks for that matter, is that they are off the radar of nearly all stock market analysts. Grantham’s fund is too big to consider net nets and other tiny deep value companies. Actually, most professional fund managers are excluded from the deep value mico & nano cap gold-rush due to the amount of money they have to put to work.
This is probably very frustrating since recessions always mean falling stock prices. Yet deep value strategies outperform strongly during an average down period, on top of offering strong protection from inflation and great performance in a strong economy.
Well selected deep value stocks follow Buffett’s most golden of rules -- not losing money -- which is why I will continue to buy net nets despite what economists say.
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