How to tell what is driving valuations

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How to tell what is driving valuations

We aim to buy stocks that trade at a substantial discount to our estimate of intrinsic value.

But what drives a stock to become undervalued? Often it is something idiosyncratic.

For example, the market can underappreciate the potential impact of a change in management, or the total addressable market of a new product.

Occasionally, however, mispricings can occur for reasons that are not specific to any single company, but instead stretch across areas that are connected by some common thread. 

Examples

Consider the following example. Mitsubishi and Kikkoman are both Japanese companies. Historically they have traded at similar multiples, mainly as a result of comparable levels of underlying growth and profitability. Since 2010, however, their valuations have markedly diverged.

Unless we can find a good explanation for this valuation gap, it looks like a mispricing. Kikkoman is a food company, its main product being soy sauce and Mitsubishi is a conglomerate with stakes in a wide range of businesses.

If a safe bond and a risky stock offer the same return, who would go for the equity?

While Mitsubishi is harder to analyse, we find no acute reasons behind its low valuation. It looks too low given our expectations for future cash flow. Similarly, we struggle to see any idiosyncratic reasons for Kikkoman’s spectacular upward re-rating.

Kikkoman’s valuation simply looks too high, and Mitsubishi’s too low. If the mispricing is not idiosyncratic, what is driving such an unusual and extreme disconnect?

One clue is in the range of outcomes for the companies’ earnings. Mitsubishi’s future profitability is difficult to predict. The business is complex and many of its earnings streams are sensitive to exogenous variables.

Kikkoman is more stable, its historical return on equity having varied by only 3 per cent from year to year. It is possible to forecast Kikkoman’s cash flow five or even 10 years out with some degree of certainty. 

Predictability

In the current market environment, this difference in predictability has had a tremendous influence on the companies’ valuations.

To understand why, we need to borrow a concept from the world of fixed income: the term premium.

Yields for long-term government bonds can be broken into three parts: inflation expectations, the expected path of real interest rates, and the term premium.

The term premium can be thought of as the compensation offered to investors for taking on a long dated risk. Logically, the term premium should always be positive, but today, term premiums in most developed markets are near zero, and some, astonishingly, are negative.

A negative term premium implies that investors are paying for the privilege of taking on term risk.

Yields can be low for good reasons, but it’s hard to imagine a good reason for the term premium to be negative. This looks like a real inefficiency—a mispricing. 

Quantitative easing

One culprit is quantitative easing. Large price-insensitive buyers of government bonds are bound to create price distortion. In this environment it makes sense for governments and companies to borrow long term, and this is what we have seen.

Ireland and Austria have issued bonds that mature in 100 years - the so-called century bonds.

One definition of risk is that “more things can happen than will happen”, and purchasers of these bonds have 100 years’ worth of potential surprises to look forward to. For taking on this enormously long-dated risk, investors receive a paltry 2 per cent a year.

A negative term premium distorts the bond market, but it also influences equities. The cost of capital for a bond is easy to see - it is the yield.

Equity cost

Equity also has a cost, which is the expected return investors demand to hold a stock. Like bond yields, the cost of equity can be broken into parts.

One part is the yield on long-term bonds. If a safe bond and a risky stock offer the same return, who would go for the equity?

Because equity investments are less certain than the repayment on a bond, equities should offer a higher return than bonds. This additional compensation is the so-called equity risk premium. 

Now we can hypothesise what’s going on with Kikkoman and Mitsubishi. Kikkoman’s fundamentals are more predictable, making it more “bond-like”.

The equity risk premium is smaller, so the term premium represents a larger chunk of the total cost of equity.

Mitsubishi has greater uncertainty, so its equity risk premium is larger, and the term premium has a smaller impact on its valuation. As the term premium has fallen to absurdly low levels, Kikkoman’s valuation has benefitted enormously, while Mitsubishi has received far less of a boost.

Graeme Forster is analyst for Orbis Investments