"At Oakmark, we decided to use a seven-year U.S. government bond as our risk free asset because that matches the timeframe we use for valuing our equity investments. Our historical analysis suggests that equity investors usually demand that an average stock earn about five percentage points more in expected return than that government bond. (More precisely, we use 450 basis points over the average seven-year AA-rated industrial bond, which averages about 50 basis points more than the government bond, but this commentary is easier to follow without that complication.)
In the early 1990s, when the seven-year U.S. government bond yielded 7%, our model said that an average stock needed a total expected return of 12% to be equally attractive. As bond yields fell, to 6%, 5% and 4%, our bogies fell to 11%, 10% and 9%. In early 2009 when the seven-year went under 3%, we said enough is enough. We simply didnt believe that bond investors buyers that were willing to hold their bonds to maturity were really accepting a return of less than 3%. Renters maybe, but not investors. So we stopped lowering our average equity discount rate when it hit 8%. Had we not done that, last summer, when the seven-year reached a yield under 1%, our equity value estimates would have skyrocketed. Then, when rates last quarter went back up to 2%, we would have brought values back down, albeit to a valuation level higher than the one we currently use.
For four years we have been saying that bond prices are not being set by long-term investors, so instead of using the actual interest rate, weve used a 3% floor. This way, our equity valuation estimates have not inflated to what we see as unsustainably high levels. Instead, we believe that stocks were, and continue to be, somewhat undervalued relative to a seven-year government bond that yields 3%. Even after the recent increase in interest rates, the seven-year has moved only a little more than halfway back toward our floor of 3%. So the declining bond market has not at all dimmed our enthusiasm for equities. We are effectively already factoring in the assumption that rates continue their upward march until the seven-year hits 3%.
Should interest rates rise further than that, to levels above 3%, we will have to examine the cause of that increase. If rates rise because of higher inflation expectations, our earnings and dividend growth projections will likely also rise, largely offsetting the valuation impact. If, however, higher rates are not accompanied by expectations of higher inflation and earnings growth, our valuation estimates would need to decline.
Fortunately, with the maturing of the TIPS (Treasury Inflation Protected Securities) market, we can easily derive investors estimate of future inflation. That presently stands at about 2% per year, which we use as an input in our growth estimates. If rates rise above 3%, we will be keeping an eye on inflation expectations to determine whether or not our equity values require adjustment."
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