We Need To Talk About Multiple Contraction

In light of recent market moves I wanted to revisit this post about discount rates and how they might impact valuation multiples (spoiler: it’s an inverse relationship). I think the post holds up pretty well. The key feature was this chart:

Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

Recall that there’s an inverse relationship between the discount rate and the multiple you should pay for an earnings stream. The discount rate has two components:

1) a riskfree interest rate representing the time value of money (usually proxied by a long-term government bond yield), and

2) a “risk premium” meant to account for things like economic sensitivity, corporate leverage and the inherent uncertainty surrounding the future.

Back in January I wrote:

By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

I am reminded of this as I read this post from Josh Brown, featuring the below chart:

Source: Bloomberg via WSJ Daily Shot & Reformed Broker

Taken together, this is a fairly vivid illustration of why the current level of corporate earnings matters far less than long-run expectations for margins, growth, and (perhaps most importantly) the discount rate.

(You do remember what’s happening with interest rates, don’t you?)

Assuming no growth, a perpetual earnings stream of $1 is worth $20 discounted at 5%.

Raise that discount rate to 10% and the same earnings stream is worth $10.

Raise it to 15% and the value falls below $7.

And so on.

Now, there’s no way to reliably predict what the discount rate will look like over time. The real world is not as simple as my stylized example. On top of that the discount rate is not something we can observe directly. The best we can do is try to back into some estimate based on current market prices and consensus expectations for corporate earnings.

So, what’s the point of the exercise?

First, I don’t think it’s unreasonable to expect some mean reversion when the estimated discount rate seems to lie at an extreme value. And yes, I counted short-term rates at zero percent as “extreme.” As the above attribution chart clearly demonstrates, multiple contraction can be quite painful.

Second, this should explicitly inform your forward-looking return expectations. Generally speaking, the higher the implied discount rate, the higher your implied future returns. There is good economic sense behind this. “Discount rate” in this context is synonymous with “implied IRR.” To look at a 5% implied IRR and expect a 20% compound return as your base case makes no economic sense. Assuming the implied IRR is reasonably accurate, the only way that happens is if you sell the earnings stream to a greater fool at a stupidly inflated price.

Do fools buy things at irrationally high prices?

Yes. Indisputably. All the time.

Does that make price speculation a sound investment strategy?

No, it does not.

“Multiple expansion” is just a fancy way of saying “speculative price increase.”

Likewise, “multiple contraction” is a fancy was of saying “speculative price decline.”

Why Do We Bother?


Oh, yeah, they have model asset allocations at that firm. But the models are all overweight international equity so no one actually uses them.

I’d like to have this framed for my office. Someone I work with said his mom cross-stitches. I told him I’d pay for her to cross-stitch this quote so I could frame it for my office. I wasn’t kidding. I don’t think there’s a more perfect illustration of the behavioral investment issues at the heart of the investment advice complex.

Great quantities of money and effort are expended to produce research, models and recommendations.

A great show is made of customized financial advice. We make a fetish of independent thinking. Of “not being afraid to stand apart from the crowd.” Of “sticking to our process.”

But in the end, it’s usually the sales process that drives investment decisions.

Permanent capital is probably the greatest edge you can have as an investment professional. If I could choose between being 50 IQ points smarter, having a massive research budget or a modest amount of permanent capital to manage I would take a modest amount of permanent capital every time.

Every. Single. Time.

Private Credit Stats

Sometimes I hear people say we “deleveraged” following the 2008 financial crisis. Sure, the consumer may have deleveraged, but I can assure you there’s plenty of debt left sloshing around in the system. A bunch of it has moved from bank balance sheets to what can loosely be thought of as the hedge fund space.

We call this private credit or direct lending. It’s huge right now in the institutional investing world. Sometimes it feels like every scrappy hedge fund guy in the world is launching a private credit vehicle.

Today, I came across a great paper by Shawn Munday, Wendy Hu, Tobias True and Jian Zhang providing an overview of the space. If, like me, you’ve been inundated with pitch decks from private credit funds over the past couple years, you won’t find much in the way of new information. But the stats are worth perusing.

Source: Munday, et al
Source: Munday, et al
Source: Munday, et al
Source: Munday, et al

If you are an allocator this is nice base rate data for the space. According to the pitch decks everyone is targeting a net IRR in the mid-teens. It doesn’t surprise me that the median IRR for the post-crisis era is closer to 10% than mid-teens.

Personally, I’m inclined think median returns over the next decade will look more like the 2006 and 2007 vintages. Anecdotally, I can tell you there are middle market deals getting done out there with six turns of leverage and 7% yields. Unless you’ve got warrant coverage, you’re not getting anywhere near 15% IRR on a deal like that.

That kind of behavior reeks of yield chasing.

And we all know what happens to yield hogs.

Eventually, they get turned into bacon.

3Q18 US Factor Returns

Below are my factor return charts, updated for 3Q18. As always, this data lags by one month, so it is technically through August 31. Note also that the more recent bout of market volatility lies outside this date range. It will fall inside the next update.

This one features more of the same. Returns to Market and Momentum continue to grind higher, leaving the more value-oriented factors in the dust.

At bottom I’ve added a snap of Research Affiliates’ latest factor valuations. They’re about what you’d expect given the return data, with Illiqudity (think VC and private equity) and Momentum at the high end of their historical ranges. Value remains at the low end.

It’s worth asking: what’s the point of this exercise?

To better understand and contextualize the following (thanks Rusty Guinn):

[T]here is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.

For a diversified portfolio, the variation in returns is explained almost entirely by the aggregate factor exposures. You’d be surprised how many professionals are ignorant of this.

Now, some of that ignorance is deliberate. There’s a reason investment managers don’t often show clients factor-based attribution analyses. The data typically supports the idea that a significant portion of their returns come from the relatively static biases (“tilts”) mentioned above.

As an allocator of capital, it behooves you to be intentional about how your portfolios tilt, and how those tilts manifest themselves in your realized performance. This self awareness lies at the heart of a disciplined and intentional portfolio management process.

Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Ken French’s Data Library & Demonetized Calculations
Source: Research Affiliates

Vulture Capitalism

Source: Wikipedia

Predictably, the Sears bankruptcy has attracted much wailing and gnashing of teeth around so-called “vulture capitalism” as practiced by hedge funds and private equity firms (here in the biz we use terms like “activism” or “distressed” investing). “Vulture” is of course used as a pejorative in these articles. Personally, though, I think practitioners should embrace the label.

In nature, vultures play an important role in ecosystems:

When vultures are unable to clean up the carrion in an area, other scavenger animals increase in population. The scavengers that tend to move in where vulture populations are low include: feral dogs, rats, and blowfly larvae. While these animals do help to remove carcasses from the landscape, they are also more likely to spread disease to human populations and other animals as well. In India, for example, the feral dog population increased significantly after vultures consumed cow carcasses poisoned with diclofenac, a painkiller. These feral dogs carried rabies and went on to infect other dogs and local people. Between 1993 and 2006, the government of India spent an additional $34 billion to fight the spread of rabies. India continues to have the highest rate of rabies in the world […]

[…] It is important to remember that even though the vulture species lacks the cute cuddly appearance of some endangered species, it is still a critical piece to a much larger, complex ecosystem. The world needs vultures to help control the spread of disease.

Likewise, vulture capitalists pick apart the corpses of dead and dying firms. Eventually that capital is recycled elsewhere in the market ecosystem.

Now, clearly this is not a pretty process. It is gruesome. It involves ruthlessly cutting costs; it involves firing good, hardworking people; it involves selling off assets and extracting cash instead of going through the “feel good” motions of reinvesting that cash into a dying enterprise. The firms that specialize in these activities are at the pointy end of Schumpeter’s “creative destruction.” It’s not exactly shocking that they’re unpopular with the general public.

But here’s the thing about “vulture capitalists.” They don’t feed on healthy companies. And there’s a good reason for this. Healthy companies are too expensive for distressed funds and buyout firms to get their claws into.

The popular notion that Sears, as a business, is dead money has been around since at least 1988. 1988! That’s thirty years. Three decades. Take a moment and think about that.

For thirty years now it’s been pretty clear the investment case for Sears rests largely on a sum-of-the-parts valuation of the real estate assets. There were very few possible worlds in which Sears would reinvent itself as a thriving retail business—particularly given brutal competition from Wal-Mart, Target, CostCo and others.

So when we talk about Sears we’re talking about the business equivalent of a sickly, dying wildebeest. Vulture capitalists consuming the carcass is simply the natural order of things. Even though hedge funds and private equity firms lack the cute, cuddly appearance of certain other market participants, they remain important pieces of a much larger, complex ecosystem.

Blood and Oil

Why do you think everyone suddenly cares about some Saudi journalist?

Which of the following seems more plausible to you?

#1. The world suddenly cares deeply and passionately about human rights in Saudi Arabia. (note that this wailing and gnashing of teeth was conspicuously absent when Crown Prince Mohammed Bin Salman decided to go full Michael Corleone on the Saudi elite last year)

#2. The US financial/political/industrial complex cares deeply and passionately about inflationary pressures and what they might mean for the future path of interest rates, is irritated that the Saudis prefer a higher oil price, and has lucked into the perfect issue with which to needle Riyadh.

Forgive my cynicism, but this all strikes me as by-the-numbers geopolitical gamesmanship.

Update (10/18/18): A more robust analysis can be found here and here. As this story has evolved it seems clearer that this is less about the US using this as leverage and more about plain old-fashioned virtue signaling.

Weapons Of Mass Destruction?

There is this meme out there that the increasing popularity of ETFs as investment vehicles is eventually going to blow up the world. This came up in a meeting I attended recently. Whenever I have these conversations what I take away from them is that a shocking number of financial market participants do not actually understand how ETFs work.

The meme goes like this: there are too many people investing through ETFs these days and when there is a nasty bear market they will all redeem from the ETFs at the same time and the ETFs will all explode. On the off chance you’re wondering how this meme got started this graphic should set you straight.

Source: ICI

As you can see, if you’re an active equity mutual fund manager you’ve got several hundred billion reasons to portray the rise of the ETF as a harbinger of doom. And so here is the first and most important thing everyone needs to know about ETFs:

ETFs are not mutual funds!

From what I can tell, the ETF-As-Weapon-Of-Mass-Destruction meme is founded on the incorrect assumption an ETF is like an open-ended mutual fund or hedge fund that needs to liquidate holdings to meet redemption requests in cash.

That’s basically the opposite of how an ETF works.

An ETF is much closer in nature to a closed-end fund that can trade at a premium or discount to net asset value over time. The difference is that certain sophisticated market participants (“authorized participants”) can transact with an ETF issuer to create or retire shares. In theory, this mechanism should keep an ETF’s share price in line with its NAV (Arbitrage 101, friends).

Here is a helpful diagram, courtesy of ICI:

Source: ICI

When individual investors like you and me want to sell ETF shares, we don’t participate in the creation/redemption process. We couldn’t participate in that process if we wanted to. Instead, we have to sell our shares in the secondary market like a stock. The price we can transact at is determined by supply and demand. This can be a blessing or a curse, depending on circumstances.

Some Grains of Truth

ETF investors do face risks as they transact in the secondary market. The biggest risk is that they become forced sellers when the market for a particular ETF is thinly traded. In that case, they’ll have to take a haircut to unload their shares. This is no different from what happens when someone tries to unload shares of an individual stock in an illiquid market. That’s Trading 101.

Thus, if you’re going to invest in ETFs you need to pay attention to liquidity. This goes for your personal liquidity (under what conditions might I become a forced seller of this security?) as well as market liquidity (are bid-offer spreads for this security going to stay reasonably tight across a range of market conditions?).

If, for example, you own the S&P 500 index in ETF form you probably don’t have much to worry about from a liquidity standpoint. This won’t protect you from behaving like an idiot as an individual, but it’s fairly unlikely you will ever have to part with your ETF shares at a 50% discount to NAV. In fact, the early S&P 500 ETFs have been battle-tested across a number of stressed market environments, including the global financial crisis. They have yet to explode.

If you own more esoteric things, however, (e.g. the EGX 30 index, high yield debt, bank loans, complicated VIX derivatives) you need to think carefully about liquidity. Shrewd traders will eat you alive if you try to unload esoteric stuff in a dislocated market. In general, it’s dangerous to assume a share of something can ever be more liquid than the stuff it owns or represents. Yes, bank loan and high yield ETF investors, I’m looking at you here.

But these risks aren’t unique to ETFs. They’re present with every exchange traded security. It’s just that mutual fund investors aren’t used to thinking about this stuff. They just buy or redeem each day at NAV.

In Conclusion

Never generalize about any security or type of security.

Securities are not inherently good or bad. Investing is not a morality play.

In fact, any time someone is presenting a security or investment philosophy as a black/white, good/bad, dualistic type of situation it’s a good sign he’s financially incentivized to sell you something.

There are smart ways to use ETFs and stupid ways to use ETFs. But that’s more a comment on investor behavior and specific implementations of ETF investment strategies than the structure itself.