Yesterday’s Financial Times featured an analysis by Lindsay Whipp titled “A gloomy anniversary for the Nikkei.”  Most investors already know the punchline:  The Nikkei, Japan’s primary stock market index, reached a peak of 39,000 twenty years ago.  Today, the index hovers in the mid-10,000s, almost three quarters below its peak.  Given the United States’ similar issues with high levels of debt, stock market (over) valuation, as well as similar monetary and fiscal responses to “fix” the initial credit crisis, investors in US equities should ask the question, is Japan the correct analogy?

Unfortunately, in many ways Japan does appear to be a reasonable corollary.  Post World War II, from 1950-1970, Japan’s GDP grew at a real rate of 8.4% annually on a per-capita basis.  It slowed to a still stellar 4.1% rate from 1970-1990.  Then, the bubble burst and from 1990-2004 Japan’s economy grew at an average rate of 1%.  The Japanese market’s slow bleed has led to a -6.4% annualized return over this period.

What happened?  Similar to what we just experienced in the US, the late 1980s in Japan saw monetary inflation that led to tremendous asset price inflation in both residential real estate and equity markets.  The government reaction after the bubble burst was very similar to the US government’s reaction to date.  The Japanese government propped up insolvent banks and built bridges to nowhere.  It redistributed existing wealth rather than allowing creative destruction to work its magic by purging excess and encouraging new development.  While Japan did use monetary policy to combat deflation, it was far less aggressive than the US has been to date and a period of mild price deflation has persisted.

The economic ramification of the analogy are clearly quite negative, but there are several additional insights investors might find useful:

• Valuation matters.  Despite very poor overall stock market returns for the period of -6.4%, our friends at the Applied Finance Group demonstrate here (slide 15) that investors who purchased the “cheapest” quintile of stocks each year were able to achieve a 6% positive return thus beating the “market” by over 12% annually.
• Overvaluation, leverage, and excessive government intervention lead to volatility.  Volatility creates opportunities as the following graph shows with the Japanese market experiencing 5 sell-offs of greater than 30% and 4 rallies of greater than 30% over the twenty year period.
  
• Unlike Japan, the US Federal Reserve has an incentive-caused bias to inflate.  One might conclude that Japan got mild deflation because that is exactly what they wanted.  Japan is a nation of net-savers, while the US is the largest debtor nation.  Savers loath inflation because the value of their bond coupons become less and less valuable.  Debtors love inflation because the value of their debt is less and less.  (Now, before one concludes that the Fed’s aggressive monetary policy will be our saving grace, it is important to remember that real growth is all that matters from the standpoint of wealth and improved living standards and all that inflation achieves is nominal growth with the very negative side-effect of mal-investment.)

In conclusion, we think that while not a perfect analogy (owing to distinct demographic, immigration, and consumer behaviors to name just a few differences), the last twenty years in Japan provide a very useful template to inform current investment decisions in US markets.  We believe a process that is oriented toward value investing, displays the patience to wait for the market to present opportunities, and is mindful of the damaging impact of an unstable currency has the potential to offer both positive absolute and relative returns in even these very challenging conditions.

The May/June edition of the CFA Institute’s Financial Analysts Journal features the article, “Should Good Stocks Have High Prices or High Returns?”  Not withstanding the ambiguity of the term “good,” the logical answer to the question is that the fair price for any investment is the future stream of cash flows the investment will provide, discounted at a rate that incorporates the expected natural rate of interest over that time period and a risk-premium to account for the possibility that the cash flows don’t occur (or the timing changes, etc.).

The article goes on to define “good” using several metrics.  One metric is the amount of leverage a firm has – low is good, high is bad.  The higher the leverage, the greater the possibility the firm goes bankrupt and the future cash flows don’t occur.  So,  based on this definition of “good”, a “good” stock should have a higher price and a lower return.  Think about it this way:  A given firm’s equity should have a higher return than the same firm’s debt because (among other reasons) the debt gets paid first and therefore has a higher probability of being paid.  All else being equal, a firm with lower leverage has a smaller chance of bankruptcy than a firm with higher leverage and thus a greater probability of paying the expected cash flows.  Thus, the risk premium should be lower and the expected return lower for a firm with less leverage.  The article highlights empirical evidence that bears this out.

Here is where it gets scary:  When asked about this issue, professional financial advisers gave diametrically opposed answers depending on how the question was asked.  When asked if they required a higher rate of return for a stock with higher leverage, 86.2% of advisers said yes.  When asked if they expected a higher rate of return for a stock with higher leverage, only 12.5% of advisers said yes.  Advisers are clearly prone to many of the same behavioral biases that affect laymen.

Two important conclusions can be drawn from the article:

1. Aspects of the stock market are NOT efficient.  When professionals answer the same question regarding valuation with opposite answers depending on how the question is framed, mis-pricings will abound.
2. When seeking investment advice:  caveat emptor.  As the article states, “avoiding investment mistakes is one of the leading reasons for using the services of financial advisers.  The value added from the advice, however, is compromised if the advisers are subject to the same biases as the individual investors.”

Many fixed income investors are familiar with the concept of duration.  It generally represents the change in the value of a bond that results from a 1% change in interest rates.  If interest rates go up by 1%, a bond currently priced at par (100) with a duration of 5 will go down in value by 5 to 95.  Check out Investor Words for a more detailed discussion.

Before we dig deeper into the application of duration to equities other than bonds, we need to take a brief digression for a quick refresher on asset valuation.  In a pure sense, investments are worth the net present value of all of the future cash flows the investment will provide.  The net present value is calculated by discounting each of the individual cash flows back to today using some interest rate.  If my discount rate (or interest rate) is 5% and I am going to get $100 tomorrow, what is that investment worth to me today?  $95.24.  Here’s the math:  $100/((1.00+5%)^1).  So, we can think about duration as the impact of changing the discount rate we use to calculate the net present value of an asset’s future cash flows.

With that background, let’s take a look at how duration applies to equities.  Equity investments have a much longer duration than fixed income investments because there is no set date for a return of principal.  An equity investment’s dividends could continue to grow and pay ad infinitum.  Therefore, equity investments are much more sensitive than fixed income investments to changes in the discount rate (i.e. the interest rate as described above).  Within equities, a stock that pays a very high dividend and whose price implies little growth (e.g. Altria, MO) will have a much lower duration than an equity that pays no dividend and whose price implies substantial growth (e.g. Google, GOOG).

As we articulate in our most recent quarterly letter, we believe the current economic environment has the potential to leave corporate earnings volatile for some time and to increase the volatility of inflation, both of which could lead investors to increase their discount rate.  So, all things being equal we believe equity investments that pay high dividends compared to those that pay no dividends and whose prices imply very high growth will outperform the overall stock market.

To illustrate why the duration on an equity is much higher than that on a bond, let us look at a couple of examples.  First, assume we are talking about a Treasury bond with a 5% coupon and 5 years until the bond matures.  Also, assume that the risk-free interest rate is currently 5%.  As illustrated in the table below, the net present value of that bond is 100.  We get to this value by discounting the bond’s annual coupons and the final return of capital at the risk-free rate.

Now suppose we purchase that bond for 100.  Immediately, new economic news comes out and the risk-free interest rate moves to 6%.  How much is our bond now worth?  The answer is 95.79(1).  The following table illustrates the changes in the value of the discounted cash flows based on the new 6% discount rate, as opposed to the old 5% discount rate.

Now that we have seen why a change in interest rates changes the value of a bond, we turn to an example of an equity.  Below, we model an equity investment that pays a 2% dividend which we think will grow at 3%.  The risk-free rate is back to 5%, but now we add in a 3% equity risk premium.  The net present value calculation tells us that an investment with these characteristics is worth 63.91.  Notice that the cash flow for the residual value is highlighted.  Unlike a bond, an equity investor is not promised a return of principal.  The residual value of the equity that exists beyond the 5 year period we have chosen to model is just the present value of the future dividend stream that we can expect a new investor to pay.  (The formula for the residual is a perpetuity:  dividend/(discount rate – growth rate).)

Rather than change the risk-free rate, we increase the equity risk premium in the final example below to demonstrate that an equity investment with these characteristics has a duration of almost 25.  A 1% increase in the equity risk premium changes the net present value of the investment to 48.03.  (48.03 is 25% below 63.91.)  Notice how sensitive the value of an equity investment can be to the discount rate.  Valuing an equity investment is a very imprecise process which is why it is important to have a very large margin of safety (i.e. an undervalued asset) before making an investment.

In conclusion, we believe the concept of duration is just as relevant when thinking about equity investments as it is when thinking about interest rate risk and fixed income investments.  For a more detailed analysis of the impact inflation has had on the equity risk premium, review Ed Easterling’s work here.  For further reading on equity duration, both Ben Inker of GMO and John Hussman of the eponymous Hussman Funds have explored this concept as it applies to the overall stock market.  Their analysis is worth reviewing.  If you would like to play along at home, you can download the spreadsheet model we used in this analysis here.

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1 Careful readers will note that the 1% interest rate increase led to a 4.21% decrease in the value of the bond, NOT a 5% decrease.  This is because a 5-year, 5% coupon bond has a duration that is slightly less than 5.  A zero-coupon, 5-year bond would have a duration of exactly 5.  This is because as an investor receives each coupon, that portion of the value is no longer subject to the new interest rate.