Market movements
Today was a challenging day for our direct equity portfolios, with our funds flat against a benchmark up 60bps.
There was a very strong “lower real interest rate” theme behind the moves, with gold stocks (NCM, NST, SBM, GOR, RRL) and secular growth names (PME, FPH, ALU, SEK) all featured in the top 20. The common driver between these groups of stocks is their sensitivity to interest rates (or in bond jargon, their long duration).
A couple things to mention. REA was one of those strong performers. It had a positive quarterly update out today and has the valuation metrics shown below.
51x forward PE, 32x forward EBITDA, and 22x sales. The stock has a market cap of over $23bn. Whilst it is a great little company, the annualised EBITDA of ~$600m seems disproportionately small, particularly given the stock is at maturity in Australia, and given that the hot housing market (which is the ultimate driver of REA’s revenues) has to cool at some point.
Still, that’s only observation one.
The second point, is that the real interest rate, which is causing secular growth stocks to re-rate, can’t get much lower. See the bottom right graph below (10 year real rate).
The real interest rate declined materially pre-pandemic, collapsed during the pandemic, and has since then has been bouncing around the bottom for about a year now.
As such its ability to fall further and drive valuation multiples higher is very limited.
Now, the limit to how negative real rates can go is the zero lower bound for nominal yields (very few countries have tried negative rates, and very few are willing to make a proper go of it, as such we feel comfortable describing zero as the lower bound for nominal yields) minus expected inflation.
Restated, zero minus expected inflation. So, the key question is how high can expected inflation go?
(Side note: I keep using italics because I’m trying to differentiate it from actual inflation, which is the variable you see in the papers, and commented on by us, and that number is currently high – e.g. 5% in the US – but it is very different from long term expectations, which are much lower.)
If inflation expectations are well anchored, because monetary policy is perceived to work, then expected inflation should not be very high, regardless of what actual inflation is doing.
Also, if we calculate expected inflation using the DKW method (estimated from bond prices, with components shown below) we get a fairly modest value. If this is correct then the simpler breakeven inflation measures that market participants seem to be focusing in on are overstating just how negative that real rate is.
It might take us a few goes at explaining that concept clearly, and I’ll have another run at it soon.
The point is despite a painful day performance-wise today, we cannot see how buying REA at c50x earnings is a good strategy for generating future outperformance.
The same goes to many of the peers (not just in the sector, like Domain, but the “growth narrative” peers, such as the aforementioned ALU, RMD, XRO etc), where, based on our calculations, the level of compound annual earnings growth as implied by their respective market caps is simply very difficult to achieve, and very difficult to believe that it will be achievable for all of them.
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Please note that past performance is not a reliable indicator of future performance.
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