Magellan calls a ‘new normal’ in equity markets

Addressing Magellan’s annual investor roadshow in Sydney last week, the fund manager’s chief investment officer Hamish Douglass said with the Reserve Bank having indicated interest rates could remain low for “possibly decades” to come, it was necessary for investors to change traditional formulas used to assess the value of a stock.

“A business in our portfolio with consistent growth around 4 per cent per annum, a decade ago where long-term bond rates in the US were about 5 per cent, that would translate into a discount rate of 10 per cent and that business would be worth about 17 times free cash flow,” Mr Douglass said.

“Currently long-term government bonds in every country in the world are below 2 per cent, so the question we have to think about as investors [is] do we think we’re going back to the world before the GFC when interest rates were 5 per cent and you should pay no more than 17 times for something like PepsiCo, or do we believe we can pay more than 35 times free cash flow and that’s fair value, or is it somewhere in between?”

Mr Douglass said many investors were understandably worried about share prices reaching unsustainable levels in the US in particular, but that today’s prices had to be balanced against the relative value of interest rates.

“Two weeks ago the US market was at its third highest point in 120 years, so many market commentators are saying there’s a bubble and to get out of the markets, but we’re saying it’s not that easy because you can’t comment on the valuation of equities until you start thinking about it relative to what interest rates were at the time,” he said.

“If you look at the risk premium between equities and risk-free government bonds, two weeks ago that was sitting at its 120-year average, and it’s now fallen below that line so if we looked today we’d say US stocks are cheaper on average than the last 120 years relative to the interest rate environment we’re in.”

Mr Douglass said Magellan was reassessing the prices it was prepared to pay for stocks, and encouraged investors to do the same if they did not want to miss out on capital growth over the next several years.

“We have lowered our overall interest rate assumptions for valuation purposes which is very important. We no longer think 17 times earnings for PepsiCo is fair value, we’re not going to 35 times earnings but we’ve moved that valuation benchmark,” he said.

“If you think it’s going to look like the past and your behaviour is that markets look expensive so we’ll just sit them out, you could be sitting them out for decades and that could be a disaster.”