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  • Chris Mayer

The Big Picture

A dialogue on the big picture...


Q: What do you think about the economy?


A: We don’t talk much about the economy around here. I’d rather focus on more concrete things like businesses and industries. Peter Lynch had it right. “How is the sneaker industry doing? That's real economics.”


Q: So the economy doesn’t matter?


A: I didn’t say that. The big picture is important. It’s just it's mostly unknowable.


Q: But... What about interest rates? The ten-year Treasury rate is under 1%. Surely you must think about rates being higher in the future. This isn’t a matter of prediction, just common sense. And that should color your choices today.


A: If it did, I think I would be making a mistake.


Q: How so? Interest rates are the most important financial input there is. It colors all valuations. With the ten-year Treasury under 1%, almost every valuation on any good business starts to look relatively attractive.


A: I think you overstate the case. Let's take an example: Verisign. Do you know the name?


Q: A little bit. Berkshire owns a bunch. I know Verisign holds the exclusive rights to be the registry for the popular “.com” and “.net” domain names. It’s a legal monopoly.


A: It’s also a great business. Huge profit margins. Tremendous cash flow. High returns on capital. Practically no capital needs.


Q: I see the stock has been a big winner, nearly tripling over the last 5 years. It trades for about 30x earnings and about a 3.2% free cash flow yield today. Expensive.


A: Is it? Demand for domain names has risen about 4% on average over the last 5 years. And Verisign’s contract with the regulatory body ICANN -- that stands for Internet Corp. for Assigned Names and Numbers -- allows for pricing increases of 7% annually through November 2024, the last four years of a six-year contract. This contract automatically renews if Verisign continues to meet certain service thresholds.


So, without getting into too many details, Verisign seems to have one of the most consistent, predictable cash flow streams around. If it holds its current valuation, you can expect returns of 11% or so annually -- not accounting for buybacks.


Q: I agree, that’s not bad… especially with rates under 1%. Verisign’s free cash flow yield is more than 3x the ten-year Treasury. Plus, it’s growing. But what if rates rise? That’s my worry.


A: Why are you worried?


Q: Isn’t it obvious? Let’s go back in 2015, the ten-year treasury rate was more than double what it is today, just over 2%. Verisign’s free cash flow yield was about 6.5%... more than 3x the ten-year Treasury rate, just as it is today.


Now… What if rates go back to 2% and Verisign trades for a 6.5% free cash yield? The stock would be nearly cut in half. I don’t mean to pick on Verisign, a name I don’t know well. But I think a lot of stocks are in the same boat. It makes me nervous.


A: Well, you’re right that a lot of stocks have enjoyed a similar valuation tailwind over the last 5 years. But I wouldn't let that worry dissuade you from owning a great business. Over a long time horizon, say, ten years, it won't matter much.


Q: Humor me, because I don’t follow. Let’s say inflation picks up and rates start to move up.


A: Okay, well, Verisign requires little additional capital. That’s a big plus in an inflationary environment. And it would be able to increase prices 7% annually, which is probably enough to exceed any inflation. If inflation exceeds 7% then Verisign would be losing ground, but I think it unlikely.


Q: Maybe you’re right. So, the stock would probably not fall as much as half, but it would face a pretty big headwind as the valuation would likely come down over time. That 11% gain could melt to low single digits even on a fairly long time horizon… possibly worse.


A: Maybe. But let’s roll back further… to 2007. The stock traded for 36x earnings and a 3.8% free cash flow yield then. The ten-year treasury was 4.6%.


Q: So, the stock’s free cash flow yield was below the ten-year treasury. Yikes. And it’s 2007, the height of the housing bubble. The world is about to tumble into the worst financial crisis since the Great Depression. Sounds like a potential disaster. I would’ve passed.


A: Well, passing on Verisign then would’ve been a mistake. If you paid the top price in 2007 and never bought it again, you’d be up 5x today. Obviously, if you added more in the downdraft, you did even better.


Q: Wow… And even though rates fell, Verisign’s valuation didn’t change that much from 2007.


A: Right. Now, again, Verisign is a great business. There are plenty of mediocre businesses out there with leveraged balance sheets, heavy capital needs and no real ability to raise prices. They will fare much worse. Those are the ones I’d worry about.


What I’m focused on is finding more great businesses like Verisign. That’s why we don’t talk much about the economy around here. It takes our eye off the ball, so to speak. I mentioned Peter Lynch before. Well, he had another famous quote that you might’ve heard: “If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes.”


*** Oracle of Interest Rates


Let’s waste a few minutes…


The caveat to the above is this: you can always come up with a disastrous scenario. "What if the ten-year rates go to 8%... like overnight? Then what! Utter destruction! Buwahahaha..." If you like to play this game, then maybe stocks aren't for you.


The other point I'd like to make: It's not automatic rates go up, as my interlocutor above suggests.


What inspired me to write the above dialogue is that I recently came across Hoisington Investment Management’s Q2 letter. I usually don’t read this sort of thing anymore, but I used to. In fact, I rummaged through my old newsletters to find the last piece I wrote about Van Hoisington. It was back in 2012.


Here’s what I wrote then after meeting him:


Van Hoisington (born in 1940) is the top man at the eponymous money management firm, which he founded in 1980. The firm operates out of Austin, and Van has a bit of a Texas drawl. With his twang, mane of silver hair, big gold ring, brass-buttoned blazer and folksy manner, he reminded me of an old college football coach at an alumni fundraiser.


He has what seems like the easiest job in the world. He manages $4 billion of assets on which he earns fees. And all he does is buy U.S. Treasuries. No man has been more right about interest rates in the last two decades. Van thought they would go down — and has thought so since 1990. So they have. As they fell, the value of Van’s bonds rose. [At the time I wrote this, Van’s fund put up 9.1% annualized returns for the prior decade - basically owning treasuries].


So what does Van Hoisington think now? Will interest rates finally turn upward? They can’t possibly go lower, can they?


“Rates aren’t going up anytime soon,” he said.


Can Van be right again? I have seen him make this same essential presentation at least three times before over the past five years. Each time, I walk out shaking my head, thinking he can’t be right.


And yet he’s been right... for three decades now. In his Q2 letter, he’s still singing the same tune. You can read the full letter here. But basically he thinks rates will go lower.


Insert the shrugging guy emoji here. I mean, I don’t know. I don’t believe in oracles. I don’t put any faith in anybody’s ability to call the macro tunes. But Van tests that faith! Was he just lucky? Will he be able to change when the time comes?


Well, the point is, it's not obvious rates go up. You can make a case they go down. Nobody knows. (Though Van seems to...)


In any case, a lot of this stuff doesn’t matter all that much. Great businesses have a way of delivering positive surprises. In my study of 100 baggers, one key takeaway for me was just how these stocks seemed to power through the ups and downs, the booms and busts.


Find those great businesses, hang on to them and leave the forecasting to Van!


Thanks for reading.


***

Published September 23, 2020

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