This article is excerpted from a letter by MOI Global instructor Patrick Brennan, founder and portfolio manager of Brennan Asset Management, based in Napa, California.
Low and Incomprehensibly Low
The second quarter was marked by two categories of interest rates around the world: historically low (US) and incomprehensibly low (various countries worldwide). Despite a jobless rate of 3.7 percent, fears of trade tension fallout and mixed economic numbers have increased expectations for US interest rate cuts. The US 10-year bond briefly fell below 2 percent during the second quarter. This would be low by any measure of past rates throughout US history. But, in this surreal world, this yield would have to be considered high yield in comparison to other nations. Europe has sported lower yields than the US for years, but the absolute and relative spreads are still breathtaking. German 10-year bonds are currently at -0.38 percent, Netherland yields are -0.27%. Remember all the negative headlines about Italy and Greece potentially breaking up the EU? Their 10-year bonds are 1.5% and 2.0%. And the crazy interest rate world has spread to, shall we say, more emerging markets. Any interest in lending money to Poland or The Czech Republic for 10 years? You will receive close to nothing or be forced to pay a couple of basis points for the privilege.
The desire for yield has also plagued the corporate world with nearly 30 percent of Euro-denominated investment grade bonds now sporting negative yields. Roughly 2 percent of the European high-yield market has negative yields. In past letters, we noted that our cable names, though leveraged, operate in far better markets than French cable firm Altice and were far more responsible in how they structured debt. Even 2 years ago, we could not have imagined the day when Altice, the true “high yield” borrower if there ever was one, would sport negative yields on certain short-term debt. That day has come.
The golden rule of finance is that a dollar today is worth more than a dollar tomorrow. How much more? Well, it depends on a host of factors, but perhaps no more important than the level of interest rate, as investors must judge whether to own a risk asset or be content to be paid the so-called riskless return. So, what is an investor to do in this type of world where rates have plummeted and stayed far lower than nearly anyone would have predicted? It is far from easy. Could an investor have predicted 5 years ago that this interest rate scenario would have persisted and gone to further extremes? We would argue “no,” but there are a host of opinions on this. The valuations on a large number of technology companies and the parade of cash-burning IPO companies suggest that investors are chasing growth in any form. Certainly, our returns would have been better served if we had more exposure to growth/software as a service/or most recent initial public offering. So, with the benefit of hindsight, we have committed an error of omission which has negatively impacted returns, but does one fix this by now chasing growth? As value investors, one could predict our answer would be “no,” but this decision admittedly may not prove to be correct for some period of time. We still see pockets of value in companies (in our opinion) unfairly tainted as secular decliners, despite possessing more resilient businesses. We also see considerable value in markets outside the United States. With several of our names trading at inexpensive relative and absolute valuation levels, we feel more comfortable with our portfolio versus investing in some of the frothier technology areas of the market or…paying money to The Czech Republic/Poland for the privilege of lending for 10 years.
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