Price discovery is one of the market’s most important roles. To place an appropriate value on a company is important when such a company is raising new monies from outside investors. How else can investors determine whether the return they expect to receive is fair given the risks they are accepting?
Interest Rates Are Crucial to the Valuation of an Assets
And the level of interest rates matters to the valuation process. Take the example of the owner of a small retail shop which is earnings €50,000 annually after tax (shortened to €50k) and such shops are selling for €500k as a rule of thumb in the area. And the owner has decided to sell the shop in five years and retire.
If bank deposit rates were 6%, what value might you place on this business today? If there are no risks to the expected €750k of cash flows, made up of the €50k annual profits and a lump-sum of €500k at the end of the 5-year period, the answer is €584k.
Let’s examine why that is. Take the initial €50k profits you expect to receive at the end of year 1. If interest rates are 6% that €50k is worth €47.17k to you now because €47.17k placed on deposit today earning 6% will compound to €50k in one years’ time. As outlined in the attached table, the entire €750k of cash flows you expect to receive over the five years are worth €584k today calculated in the same way.
If, however, bank deposits rates were 3% today that would place a higher value on the shop of €660k today. So, lower interest rates raise the value of a business. The second table highlights the value of this business (or stream of future cash flows) at interest rates varying from 6% down to 1%. The basic message is clear; the lower interest rates are, the higher the value of the business today.
At lower interest rates, you need to place progressively more monies on deposit to compound to €750k in the time given. The rationale for this is that – if you can get the same return from monies placed on deposit with a bank, what would entice you to pay any more for this business today?
For example, if interest rates were 4% and you had €633.5k to invest you would compound your monies to €750k after five years. In reverse, if you were due to receive a total of €750k over a 5-year period and interest rates were 4% today, what would entice you to pay more than the €633.5k today for those cash flows? Very little, if you are a rational investor!
This example hopefully assists readers to understand why lower interest rates are good for stock markets, and other asset prices like property.
Of course, when we value the shop like this, we are assuming no risk to the shops cash flows over the next five years. In reality, there would be plenty of risks – the risk that a competitor starts up a new shop down the road or the risk that demand for what the shop is selling goes online.
To account for such risks, investors add what is referred to as a risk premium to the bank deposit rate or the risk-free rate of interest. In the third table opposite, we have (subjectively) incorporated a 4% interest premium to account for the risks in this business. By doing so, we have, in effect, used a higher rate of interest, thus further lowering the value of this business. By adding in a risk premium, we have build in a margin of safety (a lower value) to account for known and unknown risks.
What constitutes an appropriate risk premium varies enormously across business. And therein lies the rub of the issue. Valuing risk assets is tricky, requires experience and ultimately is an imprecise science.
In that context, the arguments among investors regarding the merits of passive index tracking funds versus actively managed funds are not complete without this crucial insight. Someone still has to do the price discovery. A passive index tracking fund requires no fund manager as it simply replicates a given index.
Exchange-traded funds (ETFs) – which are stock market-listed passively managed index tracking funds – are a great innovation. They are easy to understand, they offer instant liquidity, they assure you of the market return and, with no necessity for a manager, they have lower costs. Consequently, they have put enormous pressure on the actively managed funds industry.
But make no mistake; ETFs do not assist in the crucial role of price discovery. As Howard Marks, Co-founder of Oak Tree Capital, California, put it – ‘actively managed funds carry that load and, in doing so, ETFs get a free ride off their efforts and knowledge‘.
So, while the actively managed funds industry is contracting as the passively managed funds industry is expanding the process can only go so far.
Actively managed funds will always be around, although the pressures from the growth in demand for low-cost, passively managed funds are acting to weed out the winners from the losers in the actively managed funds space in a positive Darwinian-type process, if you like.
And the winners in the actively managed funds space are likely to have highly focused investment processes that add value. There may be less of them around in the future, but more of them are likely to deliver outperformance against a relevant benchmark index.
Our own client solutions involve stocks, ETFs and actively managed funds. We are extremely conscious of costs, but who would not want to consider such outperforming global actively managed equity funds as Fundsmith Equity Fund, Smithson Investment Trust and the Swiss-based 2Xideas Library Fund. And we like the concept of niche operators, like HG Capital Trust for private equity exposure, AVI Global Trust, which ferrets out deep value opportunities on a global basis and Murray International Trust for income and growth also on a global basis. These actively managed funds are available in Europe and the three investment trusts are listed on the London Stock Exchange.
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