Investment Grade
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- By Ken Howard
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- 15 September 2020, 4:35 PM
I wanted to share a few thoughts on; "investment grade", valuation and growth companies.
In my opinion, for an asset to be "investment grade", it must be profitable. That doesn’t mean it has to be profitable today, this year, or even next, but there does have to be a real and honest expectation of profitability.
There are some obvious examples in agriculture and construction, which take many years of hard work to mature, before becoming reliable and productive assets, and they clearly have value, even though they maybe “unprofitable” for many years.
I use the phrase "investment grade" to draw a distinction with "speculative grade" and "charitable causes".
- Investment-grade assets; produce a profit which the owner can use to sustain other activities (e.g. funding living costs during retirement), and effectively represents a return on their savings, e.g. interest on savings in a bank account, rent from an investment property or dividends from a company.
- Speculative-grade assets; may mature into "investment grade" assets, but typically, at the present time, there is insufficient evidence that the; business model / technology / innovation / research / exploration etc has a clear pathway to profitability. This maybe because of a lack of capital, multiple regulatory hurdles, excessive competition etc, but for whatever reason, the pathway to profitability remains challenging. For these assets, it is better to think in terms of “probability”, e.g. what is the probability that you have the right people, with the right resources and the right ideas, so that they can find the right solution in a reasonable time frame? Overtime, with the right evidence, speculative assets may transition to become investment grade assets (or indeed, investment grade assets may become speculative grade assets).
- Charitable causes; refer to all the other activities, which are worth something to someone, but not necessarily the owner. They can be very worthwhile, for; the managers, the employees, the customers and the suppliers, but if there is no profit, they will pay no tax and provide no financial return to their owners.
Valuation
On valuation, I would like to make the follow observations; Firstly, in very simple terms, an asset is worth what someone is prepared to pay for it e.g. art, antiques and other collectables. But from an "investment" perspective, a valuation should represent the present value of all future earnings (i.e. earnings the owner can use to support other activities). There are two very important points in this statement;
- One on "future" earnings: No-one knows the future. You may have a reasonable chance of estimating short term earnings (particularly when the company has given guidance), but when you start talking about five years into the future, there are just too many unknown unknowns to believe that there can be any precision in forecasting, despite the use of numbers and decimal points. The value in a valuation, is not in its precision, but in the framework it provides for assessing the future, as it unfolds, one day at a time.
- The phrase "present value" refers to a simple mathematical formula, that discounts (reduces) future forecast earnings, into a present-day value. The discount rate is in effect the desired rate of return. This formula captures three important concepts:
- a) The time value of money. That is $100 in the hand today, is worth more than the promise of $100 in 12 months-time.
- b) A premium for risk. Investors should pay-less for higher risk assets. Higher risk, simply means a higher probability of loss. Taking on higher risk, does not actually increase the potential return. What does increase the potential return, is paying less, i.e. buying something cheaply.
To illustrate; applying a 5% discount rate, to the promise of $100 in 12 months-time, would equate to paying approximately $95 today, while a 10% discount rate would equate to approximately paying $90 today. In other words, rather obviously, if you buy the promise for $90, you stand to make more, than if you paid $95. Either way, you will still have to wait 12 months to see if you earn the promised $100.
- c) And relativity, arguably when low risk assets are offering a long-term return of say 5%, then higher risk assets, will need to offer the potential for a higher return e.g. 10%, if they are to attract potential investors.
So accordingly, if the rate of return on low risk assets reduces, to let’s say 0%, then the expectation is that investors will bid up the price of riskier assets and thereby reduce the potential return from those assets. Perhaps one of the best examples of this occurring is with residential real estate. The risks (or needs) really haven’t changed (you want a roof over your head), but the cost of borrowing has, and this has been capitalised into the value of residential real estate. As interest rates have fallen, residential property prices have risen, and because prices have risen, future returns have fallen.
Although I would hasten to add, that the logic is not linear and should not be extrapolated across all assets. To illustrate: there is a very sound argument, that when interest rates are reduced to 0%, it is because the risks in the broader economy are extremely high. Which means the business risks, at least for some companies, will have substantially increased during periods of low interest rates.
So in some cases, falling interest rates will coincide with rising discount rates, to compensate for the higher risks.
Growth companies
On growth companies; as with most things in investment markets, there are many myths and misunderstandings, like for example, if the share price is going up, it must be a "growth" company? But what I would like to focus on, is what I might call "investment grade" growth companies and the impact of falling interest rates on their valuation.
Australia has several really high-profile growth companies, that is companies that have the track record, the resources and the opportunity to deliver growth at a faster rate than the broader economy and typically due to a combination of; research and development, addressing unmet needs and a compelling competitive advantage.
To illustrate, at the larger end, investors may mention; CSL, Carsales.com and Macquarie Bank, at the smaller end, and perhaps less well known, they may mention; IDP education and Breville.
They are all profitable businesses, have strong balance sheets, pay dividends and have the capacity to deliver strong growth into the future, so how much should you pay for them?
Well the answer depends (a) on your assumptions and (b) your target rate of return.
To illustrate; if a company is generating $1 a share in earnings and paying out 80% of earnings as a dividend, and they are expected to grow earnings at 20% p.a. compound, for a decade, before maturing, then if I am targeting a return of;
- 10% p.a. I would pay $32,
However, if I am targeting a return of
- 6% p.a. I would pay $62.
In other words, even though the company's earnings are growing at 20% compound, for a decade, if I pay $32 I will only earn 10% p.a. and if I pay $62 I will only earn 6% p.a. If my goal is to make 20% p.a. I would need to buy the company for $20.
Of course, as I have said, no-one knows the future, so there is a chance, even though the forecast is for 20% p.a. compound for a decade, it may not actually happen. If the company can only grow at 10%p.a. the valuation will halve. If the company can only achieve 20% p.a. growth for 5 years instead of 10years, the valuation will halve. Of course, if these risks combine e.g. it turns out to be 10% p.a. for 5 years, instead of 20% p.a. for 10 years, the valuation will fall by 65%. Even the best companies face competition, regulation and setbacks.
So yes I am prepared to pay more, for high-quality, investment-grade, growth companies, as interest rates fall, but I will continue to remain very cautious about speculative-grade growth companies.
As always, there is plenty to talk about, so please do not hesitate to call.
More Information
Ken Howard is a Private Client Adviser at Morgans. Ken's passion is in supporting and educating clients so they can attain and sustain financial independence.
If you would like to learn more about assessing your finances, you can contact Ken or your closest Morgans branch.
General Advice warning: This article is made without consideration of any specific client’s investment objectives, financial situation or needs. It is recommended that any persons who wish to act upon this report consult with their investment adviser before doing so. Morgans does not accept any liability for the results of any actions taken or not taken on the basis of information in this report, or for any negligent misstatements, errors or omissions.