The Rules, Part XII

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I wrote the following on April 30th, 2010:

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Growth in total factor outputs must equal the growth in payment to inputs. The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now. It is very important to remember, because men are tempted to forget that financial markets depend on the real economy. If the global economy grows at a 3% rate, well guess what? In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate. Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

The value of equity is the capitalized value of the profit stream.
The value of debt is the capitalized value of the interest stream.
The value of property, plant and equipment is the capitalized value of the rent stream.
The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right. We no longer capitalize people, as if one could legally own a person today. Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets. We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three. Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits). Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates. By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency. It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining. Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition. Extreme profit margins tend not to last.

In many asset classes, investors were fooled. Home buyers bought thinking the prices could only go up. They ignored the high ratio of property value relative to what they would currently pay. Commercial real estate investors bought at lower and lower debt service coverage ratios. Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage. With equity, investor assumed that growth in asset values in excess of growth in GDP would continue. The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well. Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run. To be an excellent manager, focus on both factors — likely payments, and rate at which to discount. But who can be so wise?

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Back to the present: this is easily forgotten. Speculation can overwhelm the rational purpose of markets, which is providing liquidity to longer-term holders of the business. That gives an advantage to long-term investors to act when it is in their interests to do so. At present, opportunities are few; look for companies trading below tangible book at a single digit multiple of earnings that you think won’t disappear.

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David Merkel

2010-present, David is working on setting up his own equity asset management shop, tentatively called Aleph Investments. From 2008-2010, he was the Chief Economist and Director of Research of Finacorp Securities. He did many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, he was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, he was a leading commentator at the investment website RealMoney.com. His background as a life actuary has given him a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that he deals with in this blog. All of these goals rely on the help of Jesus Christ and his readers.