Jerry the Fighter
Last week, US Federal Reserve Chairman Jerome Powell ended the stock market party we had this summer with a short speech in Jackson Hole, Wyoming. That’s where Fed economists and other royalty from that world convene to talk about macroeconomics, interest rates, inflation, and other variables that make many investors go nuts.
Jerome Powell (whom we will affectionately call Jerry from now on) basically reaffirmed the Fed’s commitment to its dual mandate…and the market went nuts, as if this was shocking news. As a reminder, the Fed’s dual mandate is this:
- Price Stability
- Maximum Unemployment
We’re sure that somewhere someone built an AI-powered (isn’t everything nowadays?) engine that plots a forward one-year US treasury yield curve based on NLP (natural language processing) algorithms. Sane investors have better things to do. If you’re curious what drove people nuts, here’s a list of the one-liners from Jerry that left many naturally and artificially intelligent brains flummoxed:
- “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.”
- “Reducing inflation is likely to require a sustained period of below-trend growth.”
- “We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent.”
- “Restoring price stability will likely require maintaining a restrictive policy stance for some time.”
- “…we must keep at it until the job is done.”
OMG. Sell everything!
Jerry the Professor
We’re in the minority, but we liked Jerry’s speech. Firstly, the speech made it clear that Jerry knows what he’s doing. He knows his north star, and he knows the limitations of his tools. We were nerding out over the academic parts of his speech – lessons from his predecessors. We love this kind of stuff; we do the same kind of thing. We collect lessons learned by legends of our sport – investing. It appears Jerry has a similar database. Much of his speech was about what the Fed has learned…mostly by making mistakes for a century. Critics of the Fed point to those mistakes as if they will repeat them ad nauseum. Our view (and Jerry’s, it seems) is that those mistakes have been an instrumental part of the Fed’s evolution. This ain’t Volcker’s Fed; not even Greenspan’s. In the modern era, the Great Financial Crisis of 2008-09 was the last major chapter in the Fed’s education.
We loved this little history lesson because it validated our view that the Fed is a live economics experiment that now has about 100 years of institutional knowledge behind it. We believe that the Fed has got pretty good at Price Stability, even though it might occasionally overshoot or undershoot. Economic policy is not a science. Jerry reminded us of that.
Here are some of his history lessons:
- “The first lesson is that central banks can and should take responsibility for delivering low and stable inflation. It may seem strange now that central bankers and others once needed convincing on these two fronts, but as former Chairman Ben Bernanke has shown, both propositions were widely questioned during the Great Inflation period.”
- “The second lesson is that the public's expectations about future inflation can play an important role in setting the path of inflation over time. Former Chairman Alan Greenspan put it this way: ‘For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decision.’”
- History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.
Great. That’s beautiful, almost romantic, but how does Jerry’s education help us make money?
“So, what should I do?”
We get asked that question all the time. It’s a good question – if Jerry says “xyz”, what should I do with my money?
The truth is, we don’t think about this question too much. It’s not that we don’t care what Jerry says. We do. We care that he’s doing what he’s supposed to do – keep inflation within a target range and keep the credit engine of the economy greasy enough to not impede hiring and production. We care that he doesn’t deviate from that mandate, especially because of some nefarious political calculation. We believe Jerry is as apolitical as his job requires, and that’s good enough for us. We need Jerry to do his job judiciously because we don’t want bouts of mass unemployment or a run on the dollar. But more selfishly, our stock valuation methods assume price stability.
On a practical note, Jerry’s job performance directly affects the simple algebra that analysts around the world meticulously build into their multi-tabbed Excel spreadsheets. If he’s going to raise rates, stock valuations go down. If he’s going to keep rates the same, valuations tend to go up. If he says that inflation is back to normal, analyst will adjust their spreadsheets based on their interest rate prognostications. This game of reading between the lines and adjusting models is futile, in our view. Analysts tie themselves in embarrassing knots every time Jerry says or does something…
It’s about gaming expectations, isn’t it? If we expect Jerry to do something based on some data point that we saw yesterday only to see him do the opposite, then we adjust our stock valuations. In that case, what’s really happening is that Jerry’s words or actions don’t match our expectations of what we think he should do. We know better than Jerry, don’t we? No, 99.9% of us don’t. This is a crazy game.
In those spreadsheets, this futile game of expectations takes place in the denominator cell. Stocks are valued based on cash flow forecasts – the numerator – and cost of capital forecasts – the denominator. All those analysts (and us) are taught in school that cost of capital has 2 main components: cost of debt and cost of equity. What Jerry says or does directly affects cost of debt, and indirectly affects cost of equity. So, when interest rates are expected to go up, stock prices come down…because valuation models around the world say the intrinsic value of businesses have suddenly decreased because of something Jerry said.
Finance professors can dial up this concept of “cost of capital” to a level of theoretical sophistication that you’d be forgiven to think that Economics is a science. But then you realize, this is all just theory masquerading as laws of nature when all we’re really dealing with is absurd quantifications of fear or greed.
“In theory, there is no difference between theory and practice. In practice, there is.” - Yogi Berra (allegedly)
We respect our professors, but we like the Buffett/Munger approach to denominators. We suggest you do the same. It’s easier and it makes more sense. They don’t spend much time or energy on Jerry’s words. They take a long-term view based on their experience and stick to it. Of course, their view assumes that Jerry and gang will do their job – that they will keep inflation in check. Buffett and Munger use 2 concepts in tandem in their denominator:
- Long term 10-30 year interest rates
- Opportunity cost
There is some room for agreement. Finance professors and investing legends both believe that the denominator used to discount projections of future cash flows should, in some way, represent the concept of Risk and Opportunity Cost. Buffett & Munger agree with these professors about Opportunity Cost; they disagree about Risk.
Buffett & Munger shift the concept of Risk to the numerator – in the cash flow projections. They apply the concept of Margin of Safety on “projections” of cash flows before they apply it on their purchase price. The point of having a margin of safety is to allow room for being wrong…you know…the RISK of losing money by being wrong. On the denominator side, they use long-term interest rates as a proxy for opportunity costs. So, their denominator is the same for all investment ideas on their table. These ideas can be measured against each other on a level playing field. This is so much better.
We subscribe to the Buffett/Munger approach. We picked an Opportunity Cost and we stuck with it. Based on our experience 5% is our Opportunity Cost – the annualized return that we can easily earn without much risk. We apply a multiple of 20X to future Free Cash Flow – but we’ve “earned that multiple” with our rationale behind the denominator. More on this in the nerdy Appendix section. Proceed if you need a sedative.
The point is this: Be like Buffett. Let’s spend our energy on cash flows and things that affect them – market dynamics, competitive advantage, economic moat etc. Let’s leave the Interest Rate Tea Leaves reading to media personalities who make money by incessantly talking.
Appendix: Spreadsheet Nerdiness
If you’ve made it this far, contact us for a medal. You deserve it. Let’s get right into it before you fall asleep. Our denominator is a triangulation of 2 ideas (is that a bi-angulation?)
- It should be our Opportunity Cost – the best RELATIVELY SAFE return we can capture over the next 5-10 years.
- It should be a measure of Cost of Equity (to satisfy our Finance Professors).
It turns out these two concepts converge to roughly the same number: 5%. That’s how we get our standard multiple of 20X. Now before we show you this bi-angulation (?), please hear us out on a few underlying assumptions:
- We’re long-term investors – our multiples assume that the company (and its stock) will be around forever. It’s what professors call “going concern”.
- So, our multiple is, straight away, a “terminal valuation”. It’s what we expect a RATIONAL market would pay after 5 years.
- Our numerator is always Free Cash Flow to Equity. We already deduct cost of debt – actual cash interest paid by the company.
- Our minimum return requirement is 10% annualized. But we don’t account for this in our denominator. We account for this in our numerator – with a 50% margin of safety in the stock price. We buy if we find it reasonably believable that the current stock price has a 50% upside to it.
- Like Buffett and Munger, we believe that the only risk that matters is permanent loss of capital – that happens if our thesis (manifested by expectations of future cash flows) is flat out wrong. Adjusting for this risk is embedded in the margin of safety in our Expectations Investing process.
- We assume long-term inflation is about 3%.
OK. So, now for our bi-angulation:
- Our idea of a RELATIVELY SAFE return is the long-term average US corporate bond return. We’ve taken the ICE BBB Corporate Index as our proxy. The average since 1997 (as far back as the data we have goes) is about 5%.
- For our “cost of equity”, we’ve relied on valuation guru Aswath Damodaran of NYU Stern. He’s taken the trouble to estimate long-term averages for the Equity Risk Premium (ERP) in the US – a popular measure of how much a premium the market normally pays for stocks compared to bonds. Intuitively, stocks should command a premium because they are inherently riskier. The long-term ERP average in the US happens to be 5% (since 2000).
We hear the murmurs. If you’re murmuring, you’re a nerd like us. Congratulations. You’re right…Cost of equity should be equal to: Risk Free Rate + ERP! Damodaran’s spreadsheet says that Risk Free Rate + ERP = 8% (since 2000).
But, fellow nerd, if you remember your Finance 101, the denominator of the terminal valuation can (and should) be adjusted for long-term, steady-state growth. We just assume that Free Cash Flow of companies that we deem to be solid investments will grow at the rate of long-term inflation: about 3%. The risk free rate and this growth rate assumption cancel each other out.
So, the denominator = Risk Free Rate + ERP – Growth Rate = 5%. 1/5% = 20X multiple. That’s what we normally use for companies that we think have distinct competitive advantages, wide economic moats, and solid management teams. For such companies, we believe that a rational market will pay about 20X Free Cash Flow.
Well, there you have it. Enough nerdiness for one day. Do contact us for that medal.
Many Happy Returns.