By Gary Smith
The stock market has been spooked by rising interest rates. Let’s think carefully, from a value investing standpoint, about these fears.
Warren Buffett famously argued that investors should think of stocks as “disguised bonds,” in that stocks pay dividends, analogous to the coupons paid by bonds, and can be valued similarly. Bonds are routinely valued by discounting their coupons and maturation value by a term structure of interest rates.
It would be a mistake to use one interest rate to value bonds with different maturities; for example, to use the same interest rate to value three-month Treasury bills /zigman2/quotes/211347046/realtime BX:TMUBMUSD03M -0.07% and 30-year Treasury bonds /zigman2/quotes/211347052/realtime BX:TMUBMUSD30Y +2.13% . It would also be a mistake to use a single interest rate to value bonds with different coupon rates; for example, to use the same interest rate to value 20-year Treasurys /zigman2/quotes/218412477/realtime BX:TMUBMUSD20Y +1.98% with 3% and 5% coupon rates. Bonds should be valued using the full term structure, and knowledgeable investors do so.
The exact same logic applies to stocks. John Burr Williams, one of the founders of value investing, wrote that, “A constant rate is wrong, and can only lead to wrong results.” In his classic treatise The Theory of Investment Value , Williams argued that a stock’s intrinsic value should be determined by discounting dividends by a term structure of interest rates (plus risk premia), analogous to the term structure used to discount bonds. A dividend three months from now should be discounted by a three-month rate, a dividend 10-years hence by a 10-year rate.
Williams recommended that stock investors who want to use a single interest rate use an extremely long-term interest rate, specifically, the “yield to perpetuity” on Treasury bonds, which is an average of the term structure rates for bonds that never mature.
Williams’ arguments for a complete term structure never caught on. Instead, academics and stock investors generally use a single interest rate, typically a short-term rate. For example, finance textbooks authored by Copeland and Westin; Body, Kane, and Marcus; and Body and Merton all use the three-month Treasury bill rate. The textbooks authored by Brealey and Myers and Ross, Westerfield, and Jaffe use one-year Treasury bills /zigman2/quotes/211347042/realtime BX:TMUBMUSD01Y +1.75% . BofA Merrill Lynch and Goldman, Sachs have used 5-year Treasury rates. JPMorgan has used the 10-year Treasury /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y +3.32% rate.
The use of a short-term rate is sometimes rationalized by the argument that investors intend to hold stocks for only a few months. This is akin to saying that investors who intend to sell a 30-year Treasury bond after three months should value the bond by discounting 30 years of coupons by the three-month T-bill rate. This argument is clearly wrong for bonds and it is also wrong for stocks.
The insurmountable problem with using a single interest rate — short or long — is that the valuations zig and zag unreasonably as the term structure twists and turns. Between March 31, 2010, and June 30, 2010, for example, the six-month and one-year Treasury rates were stable while long-term rates fell by almost a full percentage point. Investors using short-term rates wouldn’t change their valuations; investors using long-term rates would increase their valuations dramatically.
Between Dec. 31, 2007, and March 31, 2008, Treasury rates beyond 18 years increased while shorter-term rates collapsed. Investors using long-term rates would conclude that stock valuations had fallen, while investors using short-term rates would draw the opposite conclusion. They could both do better using the complete term structure.
Long-term rates typically are above short-term rates to compensate investors for the greater market value risk. The current downward sloping term structure past one-year rates indicates that and bond investors expect interest rates to be lower in the future than they are today. They may well be wrong, but current interest rates are what investors have to consider when deciding whether to buy stocks.
The large jump in short-term rates is indeed striking but long-term rates have increased only modestly — and long-term rates are more important for valuing stocks. Since June 1 through earlier this week, the S&P 500 /zigman2/quotes/210599714/realtime SPX -1.90% had fallen 11%, so that the current dividend yield on the S&P 500 is around 1.75%, compared to a 30-year Treasury rate of 3.70%. If dividends grow by around 2% a year, on average, over the next 20-, 30- or 50 years, stocks will be the more financially rewarding investment.
More generally, investors should value stocks using a complete term structure of interest rates. For those who insist on using a single interest rate, the best rate is an extremely long-term rate such as the yield to perpetuity recommended by John Burr Williams — which, as far as I know, no one uses. The worst choice is short-term rates — which are also the most popular.
Gary Smith is the Fletcher Jones Professor of Economics at Pomona College. He is the author of “The Money Machine: The Surprising Power of Value Investing” (AMACOM 2017), author of “The AI Delusion,“(Oxford, 2018), and co-author (with Jay Cordes) of “The 9 Pitfalls of Data Science” (Oxford 2019).