Tech and Bonds, the bigger they are the harder they fall: 2013 Q3 letter
Dear Friends,
We hope you had a pleasant summer with family and friends.
The third quarter of 2013 saw global financial markets encounter some turbulence, driven largely by fears of central bank monetary tightening. The Federal Reserve issued a series of statements early in the summer, essentially warning investors the era of large-scale monthly bond purchases and ultra-low interest rates was approaching an end. The wordsmiths at the Fed settled on the word “taper”; we assume in the hopes of conjuring an image of a slow, gentle ride into the QE sunset. Of course, the bond market’s response was anything but gentle as investors began aggressively selling long-dated bonds. Our view for some time now has been that long-dated bonds could see sharp, sudden drops in value if rates begin to rise. The summer was a reminder for bond investors of how suddenly this can happen. On May 1, the 10 year treasury yield stood at 1.66%. By early July, it had risen past 2.66% (a full one percent move) – a level not seen since August 2011, during the summer debt ceiling negotiations. After witnessing the speed at which bond yields spiked, the Fed backtracked on its tapering guidance and yields have dropped a bit. However, we would caution bond investors not to succumb to complacency. There is a high likelihood rates will rise much higher over the next several years. We remain convinced that long-term bonds offer very low prospective returns and recommend short term and floating rate fixed income investments as an alternative.
We won’t spend much time on the budget morass in Congress, except to say we wish there were more responsible adults in the negotiating room. At the time of this writing, Congress is unable to pass a budget which has led to a government shutdown. Meanwhile, an even more critical deadline looms in two weeks, when the US Treasury reaches the debt ceiling set by Congress and is unable to pay for contracted services and perhaps even repay Treasury bondholders on time. This annual cycle of budget brinkmanship has made many bond market participants seriously re-consider the once unthinkable idea that the US may default on debt obligations. Should Congress decide to flirt again with default, we expect a replay of 2011 where stocks sold off and bond yields rose.
Over at the wsqcapital blog, we recently published a piece about how interest rates impact stocks and business enterprises in general. In the post, we listed four ways in which rising interest rates impact stocks:
- Investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.
- Rising rates make bonds a more attractive investment alternative for investors.
- Rising rates also mean higher borrowing costs for companies forcing them to reduce investment expenditure to meet increased financing costs on existing debt.
- Businesses and governments use higher interest rates to evaluate future projects; marginal projects or investments are shelved if they are no longer viable due to higher borrowing costs, slowing activity.
All these factors in tandem weigh on stock prices and are reasons for stock investors to be cautious when interest rate increases appear likely. The current low interest rate environment and monetary easing has pushed up stock valuations and we believe there is limited upside for investors when the market is already trading at 17 times earnings, well above the historic average of 14. That said, we continue to see pockets of value within certain sectors that have fallen out of favor with investors.
The past few months have also provided a few stark reminders of the speed at which technological changes can impact companies previously considered unassailable. A list of former blue-chip tech stocks that have fallen on lean times include: HP and Dell. Furious competition from Asian manufacturers and low levels of product differentiation have decimated PC makers. The rise and fall of these companies seems positively glacial though, when compared with the fate of firms producing cellphones and mobile technology in general. Palm, Motorola, Nokia, and even Blackberry have found their once-enviable businesses hollowed out as touch-screen driven smartphones were created and then adopted with fervor by consumers and businesses.
In some ways, the mobile phone sector has made the same transition Internet companies did a few years earlier. Early internet usage revolved around e-mail and very simple forms of media. As bandwidth and processing power improved, usage migrated to much richer media including video. This trend continues as film and TV distribution steadily migrates to the Internet. Mobile phones followed a very similar trajectory. The first internet connected phones offered very simple and limited functionality. As data capacity improved, Blackberry was able to create a compelling product by offering reliable e-mail service on your phone. Palm meanwhile continued to be the gold standard in mobile organizers with its pilot line of digital assistants. Touch-screen enabled smartphones starting with the iPhone pushed aside all other devices by offering a single package that was capable of taking pictures, making calls, receiving e-mail and providing a more vibrant mobile Internet experience than ever before. A rich internet experience on a device that fits in your pocket became the must-have application for a younger generation accustomed to constant connectivity.
In retrospect, it all seems rather obvious. However, it would have been difficult to predict, on the eve of the iPhone’s debut, that one of the biggest winners in mobile technology would be Apple. There was little to suggest then that the former PC maker, which had almost gone under a few years prior, would emerge with the winning solution. It would have been tougher still to see that Apple’s primary competitor would be an open software platform offered by a competitor with limited interest in making devices and a business strategy that revolved almost entirely around offering services and search on smartphones. Yet, Google has marched ahead of Apple in terms of platform penetration with its Android product. We have a better handle on technology than most, but we continue to caution investors that the pace of change in the business of technology is frantic. Business models that looked bulletproof only a couple of years ago, now lie in tatters. To be an effective investor in the technology sector requires constant vigilance.
We continue to advise investors to keep their portfolios oriented towards long-term goals and exercise some caution, by maintaining judicious limits on their holdings of long-term bonds and speculative stock. Both the interest rate and equity cycles suggest lower future returns from risky assets.
Regards,
Louis Berger Subir Grewal