The real return matters

Once upon a time when you bought a government bond to receive a yield of 2% and the inflation rate was 1%, your real return was 1%.

When bonds were yielding 0.5% and inflation was 0.5%, the real return was 0%. At least investors weren’t losing money.

Heck, when German 10 year bonds were yielding negative 0.5% and inflation was negative 0.2%, investors capital remained mainly intact.

Now that bond yields have risen sharply, many holders of those bonds have lost capital. If you are not aware, when the price of a bond falls, the yield inversely rises. And vice-versa.

Today, if you are tempted to or are pondering buying a U.S. government bond, you will receive a 4% yield but when inflation is 7% (and I’m being kind), your real return is Negative 3%.

With this losing prospect, (unless you seek riskier or distressed opportunities) many investors are choosing to either sell their bonds (and realising capital losses) or not buy them at all.

This is exacerbating the selling or general distaste of or for bonds and that means prices continue to fall as bond yields rise further.

The latter is a problem for governments or companies who need to issue debt. Their interest (coupon) repayments costs are higher than recent times.

If you are in business, the cost of (capital) borrowing is now more expensive.

But, if investors are selling bonds or choosing not to buy them, logically that means those intended funds are remaining as cash.

The real return for cash is worse than being in bonds.

Real Estate may yield 3% or 4% but its real return isn’t any better especially if you need to account for taxes and any borrowing costs.

Commodity prices do correlate well with inflation and worthy of investment merit although they don’t produce income or a yield per se.

This brings me to the equity market.

Generally speaking, valuations of many equity markets are not demanding in their own right.

When compared to their real return (earnings yield minus inflation) they are presenting a slightly better proposition than government bonds.

The S&P 500 has a forward P/E of 16, thus its earnings yield (divide the PE ratio of 16 into 100) is 6.2% and so when we subtract a 7% inflation rate, it becomes slightly negative.

That is better than the (3%) real return from a 10 year government bond.

S&P MidCap 400 P/E is 13 so its earnings yield of 7.7%, making the real return slightly positive or breaking even.

The Chinese equities market has a P/E of 10 which calculates into a 10% earnings yield. Subtracting the China inflation rate of 3% (its actually 2.7%) renders a positive real return of 7%. When also you ponder converting USD into a weak Yuan…….Whoa !!!

If those index examples are not enticing enough or too risky, then individual equities may offer a better return whilst possibly taking less risk.

There are companies with terrific franchises trading at P/E ratios of 8 (or an earnings yield of 12%) with real businesses, hard assets and have little to no debt.

Instead I’ll look at companies that have real businesses, with hard assets and current cashflows. The ones which don’t have any debt or only a little.

The ones with P/E ratios below 8.

And if they have debt, some of them issued their bonds cleverly such as Apple’s recent 40 year maturities on a yield of 2.8%. This implies that Apple Inc. is more creditworthy than the U.S. Government.

I like the the type of companies whose businesses are solid and don’t rely on the ‘kindness of a stranger’ to use them. Companies who may have market share or pricing power. Where they have balance sheets and income statements which suggest that one year of EBITDA (even if its discounted and reduced) would easily cover all of its debt, where its current assets could pay off the whole of its total liabilities or where I don’t want to pay too much for an inflated amount of goodwill.

With a little more movement in markets and adjustment in corporate valuations, equities could once again carry the moniker of T.I.N.A. …….There Is No Alternative.

More so, with all this cash sitting around earning negative real returns.

October 12, 2022

by Rob Zdravevski

rob@karriasset.com.au