This post has been borrowed from Lauren Templeton Investments; a fund manager colleague Nigel Littlewood met in Omaha this year. Their summary of the end of QE and investing in such an environment is punchy and easy to understand. Their perspective is the same as that used to justify buying QBE in Australia this year by some investors.
I hope you enjoy their commentary.
If you picked up
any given text book on investment and turned to the subject index in the back
to locate the discussion on “QE taper” or “fiscal cliff” you would likely
come up empty. Despite the void, the market has awarded primacy to these
subjects over the past year, and generally speaking, company fundamentals
have taken a backseat at times. In light of the Federal Reserve’s
announcement last week that it will postpone its tapering of $85 billion in
monthly bond purchases, it has become clear that these government policy
sideshows will likely maintain the spotlight in the markets over the
near-term.
Although it can be frustrating for a fundamentally driven value investor to see the markets propelled by policy announcements, sudden reversals or fearful sell-offs among near-term speculators can be equally rewarding for the bargain hunter. Given the Fed’s cold feet, it seems likely that speculation surrounding the tapering of bond purchases and now the looming debt ceiling talks in Washington will stay with us in the near-term. We suspect that one of the likely reasons that Bernanke and Co. hesitated with the widely expected September reduction in bond purchases was owed to concerns over the likelihood of another fiscal interruption a la the possible government shutdown. Other reasons for a pause could be owed to the fact that despite no reduction in bond purchases to date in 2013, rates have already tightened significantly during mid-2013 on the basis of Fed rhetoric. Finally, we cannot dismiss the fundamental observation that since the same mid-summer interest rate episode and the resulting sell-off in emerging market currencies, many emerging market exporters have now seen their near-term prospects rise on the basis of their cheaper currencies (think competitive devaluation in global currencies). As we know, this represents a potential loss in competitiveness and market share for exporters in countries whose currencies gained by comparison (U.S. and Europe, namely), also presenting an unwelcome curve ball in the face of rather fragile developed market economic improvements. Whatever the underlying cause, it seems reasonable to anticipate additional price volatility as the current policy of bond buying is not sustainable on an indefinite basis. Having addressed near-term events, let us take a step back, and focus on the longer-term picture. From a rational perspective, it seems most probable that the thirty plus year bull market in bond prices will continue to unwind, and that interest rates are likely to be higher in the medium-to-long term. In our experience manias end when the euphoric buying of irrational participants ceases. In 2000, it was the day traders bidding up stocks on margin, in 2006 it was real estate speculators buying second and third homes with exotic adjustable rate or negative amortization mortgages, and in 2013 it is the Federal Reserve bidding up long-term bond prices with money it simply creates. The only question remaining is the pattern of the descent; drawn out and orderly, or the opposite. The pattern of this unwinding is frankly anyone’s guess. Many investors seek to profit from the possible decline in the bond market by selling-short long-dated treasuries with high duration, or through derivatives that profit from rising interest rates. For those investors with less stomach for the risks that accompany selling short or employing derivatives, there are other options. To begin, investors could focus on businesses that should continue to gather fundamental strength in the face of higher interest rates. One company that we have discussed in the past and continue to favor is the cash-handling and security firm, Brinks Co., based on what we believe to be its fundamental benefit from higher interest rates that reflect a higher velocity of money throughout the economy. |
A second firm, and
for that matter group of firms that we believe should also experience a
fundamental tailwind from higher interest rates is the life insurer Metlife,
as well as competing life insurers and then to a somewhat lesser degree,
reinsurers. The simple reality is that the extended period of low interest
rates that have been in place since the financial crisis, coupled with lower
economic activity, has made business conditions difficult and valuations
depressed for Metlife and peers on a historical basis.
The fundamental reason for this difficulty is owed to the life insurer’s business model. Life insurers collect insurance premiums and invest them more on a relative basis—vis a vis other insurers—into longer dated bonds and treasuries, where yields have compressed to paltry rates under the Fed’s assorted QE programs. This business model makes life insurance firms resemble the more “bank-like” of the insurers in the sense that they derive a larger portion of profit from “spread income” than other types of insurers such as property and casualty. Put another way, given the nature of their long-term policy contracts, life insurers invest their float more heavily in fixed income, and for that matter fixed income with longer-dated maturities, in order to keep an appropriate match between assets and liabilities. In turn, as interest rates increase, life insurers are by necessity buying fixed income securities that are falling in price, and logically these securities are becoming more attractive from an investment return standpoint. Philosophically speaking, and as we have noted many times over, we like this approach towards investment. To purchase securities falling in price today for the benefit of higher future returns is rational behavior, in our view. We appreciate that life insurers will be compelled to do so. Second, and perhaps more important to the share price of the life insurer, the marginal purchase of bonds with higher yields should increase future investment profits (which comprises a large share of overall profit), which in turn drives higher returns on equity, and by extension rising returns on shareholder equity should logically increase the present value of expected net equity flows. Given that investing in higher yielding securities eventually leads to higher returns on equity for the life insurer (assuming cost of funds do not rise faster, etc.), and the market perceives that future returns on equity will continue to hurdle the cost of equity on a near-to-medium term basis, then it is more likely that the share price reflects a premium to book value, versus the current discount; Metlife currently trades at 0.9x 2013 estimated book value. Over the past ten years, the shares have traded at a median price to book of 1.2x. The catalyst in our view to Metlife realizing a premium to book value in its share price relies on the firm achieving a return on equity that approaches its pre-financial crisis levels of approximately 14-16% during 2006-2007, versus the current level of 11.5%. Most importantly, we believe that higher long-term interest rates represent the primary key to unlocking a fundamental reversion to pre-crisis levels of return on equity. Interestingly, the thesis described above has gained traction in 2013, for instance over the course of the mid-summer spike in interest rates, shares in life insurers such as Metlife rallied in step. Even so, with returns on equity still depressed versus pre-crisis averages, and a valuation that remains discounted to book value, we believe that Metlife shares continue to trade at levels materially less than intrinsic value. Additionally, during the surprise announcement from the Fed last week that tapering would be postponed for the time being, shares in Metlife fell in price. Basically, as the market focused on the policy sideshow of postponed tapering, it sold off Metlife shares in a knee-jerk reaction. We believe that observation makes our discussion particularly relevant to the current environment and the remaining uncertainty surrounding Fed tapering. In sum, we see the potential to add additional shares in light of any near-term volatility that may be created on the basis of speculation surrounding Fed policy, or even fiscal policy if a government shutdown ensues and interest rates temporarily compress in a flight to safety (or worry over a possible recession if the shutdown persisted). We appreciate your continued interest in our firm. If you would like to learn more about the registered investment advisor Lauren Templeton Capital Management, please visit us atwww.laurentempletoninvestments.com. |
Lauren C.
Templeton
Scott Phillips
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