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Peter Elston: Long-term growth prospects may be rosier than you think

Peter Elston, chief investment officer of Seneca Investment Management, considers the general long-term prospects for growth and what it means for value investing.

Peter Elston

By Peter Elston, Seneca Investment Manag...
Thursday August 10, 2017

The concept of ‘intrinsic value’ is at the heart of Benjamin Graham and David Dodd’s 1934 framework that would later be known as ‘value investing’. Alongside this, another framework known as ‘growth investing’ evolved, to the point where many now think of ‘growth’ and ‘value’ as being independent of each other.

This is wrong. While it may be possible to buy a ‘growth’ stock without assessing its value, it is impossible to calculate intrinsic value without assessing growth. After all, intrinsic value is the present value of future cash flows. These future cash flows must by definition be growing in relation to each other, whether at rates that are positive or negative.

This same point was made by Warren Buffett in his 1992 chairman’s letter: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”

In this blog post, I look at the general long-term prospects for growth that one might build into calculations of intrinsic value.

Here is what I think is the most interesting question of today, or at least in the world of investing: does the current -1.5 per cent real long term Gilt yield reflect a bleak economic outlook or is it what is required to get growth going?

It can’t be both. And it has to be one or the other. There is a fork in the road. One leads to purgatory, the other to paradise. Make the wrong choice and you’ll have more than egg on your face.

Let’s look first at the idea that the negative real yield reflects a bleak outlook. The theory here is simple: as an economic agent, one has a choice. One can either invest in financial assets such as bonds, or in the economy via real assets that will provide a return commensurate with broad long-term GDP growth.

Theory says that both should track each other. If economic growth prospects decline, bonds become relatively more attractive. As investors buy them, their prices rise and their yields fall, thus redressing the balance.

In other words, the fall in long-term real interest rates from 4 per cent in 1994 to -1.5 per cent today reflects a substantial decline in long-term economic growth prospects.

The other theory is that long-term real interest rates reflect expectations for future monetary policy, monetary policy whose role is to promote growth via full employment and price stability.

UK real interest rate since 1990

Source: World Bank

It just so happens that for various reasons the natural real rate of interest currently is very low (negative). And as economist Paul Samuelson famously observed, at a permanently zero or sub-zero real interest rate, it would make sense to invest any amount to level a hill for the resulting saving in transportation costs. Like it or not, hill-levelling still constitutes economic activity.

But fear not, there is a simple way to test which theory is correct. If bond yields reflect a bleak outlook, there should be a positive correlation between real long-term interest rates and subsequent real returns from equities. Why? Because growth is a huge determinant of equity returns.

In the case of the US, it turns out that there exists no positive relationship between bond yields and subsequent equity returns. In fact, the relationship is very slightly negative (though the R-squared is practically zero).

The implication of this is that the long-term prospects for growth may in fact be rosier than many think, and thus intrinsic values higher.

Peter Elston is chief investment officer of Seneca Investment Management. All views are his own and should not be taken as investment advice.

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