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Sir Isaac Newton and your portfolio

By Roger Montgomery

Sir Isaac Newton and your portfolio

Interest rates.  What would we do without them.  To financial journalists they are the gift that keeps on giving.  Financial newspapers would be much lighter if not for their vicissitudes and the speculation that surrounds them.  But to a fund manager they can be the bane of one’s existence. 

Many immediately understand the inverse relationship that exists between the interest rate on a bond and the bond’s price.  Because the coupon payment of a bond is fixed between issue and maturity, when the rate of interest that a subsequent investor wants goes up, the price he must pay for the bond falls.  Only that way can the fixed coupon payment provide a different rate of return.

It is however surprising to many that the same relationship exists for all assets.  That is, if interest rates rise their value declines.

Imagine for a moment you had an asset – any asset, it really doesn’t matter what it is – and it is going to produce an annual $1 million for ten-years.  Now, you know that a million today is worth a great deal more to you than a million in a decade’s time and so we have to discount the future years’ cash flows to arrive at a present value.  For example, adopting a 2% interest rate as our discount rate, we find that $1million in ten years time is worth $820,000 today.  At 10% that $1 million in ten years time is worth just $386,000.

Lesson one is that the value of future cash flow is lower when interest rates are higher and vice versa.  And that explains why Warren Buffett likened interest rates to gravity saying in 2013 “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”

The intrinsic value of an asset is the sum of the present values of all the cash that can be extracted from an asset over its useful life.  And if we add up all the present values of a $1 million dollars received every year for ten years, we arrive at $99.83 at 2% and $71.45 at 10%.  Once again, we observe that when interest rates are higher the value of an asset is lower.

And why do we care what happens to the intrinsic value of an asset when interest rates change?  Because, in the long run, prices follow changes in intrinsic values.  That’s right.  You can forget China, Greece, Brexit, Trump or anything else.  All that will matter in the long run is the change in intrinsic values. 

Even Ben Graham, the founding father of security analysis was able to observe this, without the benefit of a computer mind you, when he said (paraphrased by Buffett); ‘in the short run, the market is a voting machine, but in the long run it is a weighing machine’.

So what do you think will happen to asset prices when interest rates eventually rise again?  Don’t be mistaken; ‘This time’ will not be different.  Asset values will decline and share prices will eventually follow.

We can see this observed in recent history.  In the US between 1964 and 1981, interest rates rose.  During this time the average return from the US S&P500 stock market index was in the low single digits – about 3.6% per annum. 

Between 1981 and 2000 interest rates declined substantially and the average annual return from the S&P500 was almost 15%.  Since 2000 interest rates have continued to decline and the implied equity risk premium has risen to compensate meaning the combined total has been remarkably flat.  In this environment the S&P500 has returned just 2.5% per annum. 

I don’t know about you but rates cannot fall much lower and in environments where they remain flat or rise, we should expect too much from the broader stock market. 

You can beat the stock market by owning a portfolio of extraordinary businesses that grow in intrinsic value at a rate that more than offsets the decline from rising interest rates. 

So as speculation about a slowdown in Chinese growth or the implications of Mr Trump winning the US Presidential Elections begin to heighten volatility – itself a subject of navel gazing – just remember how important interest rates ultimately are in the scheme of long run returns and buy businesses that are growing in intrinsic value.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!