THE SECRET PM: NIFTY FIFTY

“Men marry because they are tired; women, because they are curious: both are disappointed.” That quote from Wilde’s, The Picture of Dorian Grey, neatly describes the dilemma faced by European investors today. “Giving up” and buying bonds is going to leave you disappointed with your returns, but so is “optimistically” buying high-quality stocks.

The average level of debt across 22 developed countries, as measured by Mckinsey, is 280%. Such high levels of debt carried by developed world consumers, companies, and governments is radically reducing the demand for new borrowings. With essentially no overall demand for new credit in all of the developed world the price of credit, that is interest rates, has fallen to extremely low levels.

Low government bond interest rates together with low corporate default rates translate into very low corporate bond interest rates. Moody’s 30 year US corporate bond index, for example, has a yield of 4.46% – around an all time low. In other words US corporate bonds are capitalising long term corporate cash flows as a PE ratio of 22x. It should therefore come as little surprise that the PE ratio of the S&P 500 is roughly 20x. The US stock market is discounting corporate cash flows much like the bond market. There is no proverbial “free lunch”.

The challenge for investors going forward is that there is precious little precedent for long term corporate interest rates remaining sustainably below levels of 4.5%. Long term (30 year) risk-free interest rates at levels below 3% have historically been seen only during that other period of no credit demand, namely the Depression, and during such economic weakness corporate defaults are very elevated. This low corporate discount rate, high PE ratio combination typically serves as an anchor holding back the overall stock market performance for many years, just ask the Japanese. The S&P 500, for example, went sideways from the late 1960s until the 1980s, precisely a period which started with very low interest rates.

Simply put we face a future of low bond market returns and low stock market returns. Accepting this prognosis is hard. Investors active today have experience that is anchored to the 7-10% stock market returns that occurred from the 1980s until today. Investors for some reason choose to ignore that interest rates in the 1980s were double digit. All returns to capital were high then. By denying the low future returns on offer in both bonds and stocks investors look at today’s bond yields and feel like they have no alternative but to buy stocks.

TD Ameritrade, one of the US’s largest stock brokers with over 6 million customer accounts, described this situation on its recent conference call: “We haven’t seen client cash as a percentage of assets at these [low] levels in a long time. Margin loans are at records, client cash is at low levels. Net buying activity is at levels we haven’t seen… I think most investors don’t know where to go right now, but they’re going into equities.”

In Europe this year the situation is even more extreme as technical factors, such as banks’ liquidity requirements and Central Bank purchases, push long term risk-free interests to roughly zero. German 30 year bonds trade at a 0.5% yield, France 1%, Denmark 0.6%. Regulations demand that banks hold more risk-free, liquid assets, making banks “price insensitive” buyers of bonds. The ECB similarly is a price indiscriminate buyer. Investors on the other hand have no need to buy zero yielding bonds. But with cash deposit rates also zero (or negative for large deposits) at custody banks like Bank of New York Mellon, investors are left with a choice between a certain zero return in bonds, a certain loss in cash or investing in stocks. Nobody likes a certain loss, even versus a dangerous gamble. Surprise, surprise the FT reports that a record $35bn has flowed in European equity funds so far this year.

If bonds and stocks are going to produce equally pitiful future returns then picking one over the other is not necessarily wrong. But where investors are going wrong is what they choose to buy wth in the stock market. When trying to decide what to buy in the stock market investors naturally look at the tepid European economic growth and gravitate to “bond proxies,” in other words companies with very little risk to profits. These companies cash flows are seen as certain as bond coupons even in this low growth environment . Examples include diabetes franchise, NovoNordisk; lense maker, Essilor; cosmetic giant, L’Oreal; enzyme maker, Novozymes; distributor, Bunzl plc.

Interestingly this is exactly the same behaviour that occurred in the US in the late 1960s, and gave rise to the folklorish “nifty fifty”. In the late 1960s low interest rates coaxed investors into bidding up the prices of reliably growing US companies. In 1972 the PE ratio of Coke hit 47x, Johnson & Johnson 62x, Merck 46x, and Disney 81x. Seeing little return available in bonds investors in the late 1960s saw no alternative but to invest in stocks, and moreover, they perceived the risk from investing in the best of breed companies was low. These companies were for all practical risk purposes “bond equivalents”. Indeed investors were right that these great companies would continue to grow profits and prosper, but they were wrong that future profits could be bought at any price. An investor who bought these dependable stocks at the end of 1972 would have had 50 percent less wealth at the end of 2001 than an investor who bought the S&P 500. (http://economics-files.pomona.edu/GarySmith/Nifty50/Nifty50.html).

Looking across Europe’s nifty fifty revival today we find “intimate” medical product maker, Coloplast, priced at a PE ratio of 50x. NovoNordisk, L’Oreal, and Novozymes are all priced around 40x, with Essilor and Bunzl around 30x. Zara brand owner, Inditex, is priced at 36x. Lindt, the chocolate maker, is at 36x too. This is remarkably similar set up to the late 1960s and early 1970s. Guaranteed low returns on long dated bonds is leading investors to buy the stocks of the most secure cash flow companies with increasingly less regard for price. Geberit, Reckitt Benckiser, Compass Group, Assa Abloy, AB Foods, Whitbread, Dassault Systemes, Luxottica may all fit into this group. At these prices, instead of a sure very low return in bonds investors are going to get at best a very low return in Europe’s nifty fifty and at worst suffer significant capital losses.

Let’s take Coloplast as an example. Coloplast grew very fast from 1998 through 2008, revenue reported went from 2bn DKK to over 8bn. This growth was the result of a massive increase in invested capital, including one large acquisition. Capex averaged more than 10% of sales, twice the level of depreciation. Total invested capital, excluding goodwill, grew from 600mln DKK to 6,000mln DKK.

Big investments came hand in hand with big cost inflation and declining asset productivity. The consequence being gross margins of less than 58% in 2009, a multi-year low. Operating margins around 15% resulted in net profit in 2009 of 800mln DKK. The stock traded at a market cap of 16bn DKK.

Quick to recognise they had a problem on their hands the board appointed a new CEO in October 2008, Lars Rasmussen.

Lars ceased growth investment: capex was just 2.5% of revenues in 2011. Production was relocated from Denmark to low cost countries like Hungary and China. The R&D department was streamlined: 342mln DKK was spent on research in 2012 less than the 415mln spent in 2008.

By 2014, total invested capital was unchanged from the 2008 level but thanks to all the management actions the company operated at record efficiency. Gross margins nearing 70%, miles ahead of sector peer, CR Bard, at 62%. Operating margins at 33%, some of the highest ever reported in medtech: on par with the levels reported by the dominant pacemaker company, Medtronic, in its best years in the yearly 2000s. All together Coloplast’s net profit has grown from 800mln DKK in 2009 to roughly 2,500mln DKK.

In a sentence: Lars Rasmussen’s actions enabled Coloplast’s 5.5bn DKK of invested capital to go from earning 0.8bn (15%) to earning 2.5bn (45%). An astonishing improvement. Coloplast is certainly a best of breed company that is executing at the highest level in a stable industry, a “bond proxy” if ever there was one.

But investing in Coloplast today is not risk free. It’s market cap has risen in tandem with its earnings improvement, from 16bn DKK to 114bn DKK. Today, at 114bn DKK, Coloplast is valued at more than 50x profits. Coloplast will need to report operating margins of over 40%, higher than some biotech companies, in the next 5 years if it is to deliver profits of 4bn DKK, which would still leave the stock on nearly 30x profits.

Investors buying Coloplast stock today hoping for better than bond market returns are relying on it breaking records for medtech profitability. How likely is that? The company relies on government health care systems, how much further can it expand gross margins above peers? To grow the business outside of Europe the company has had to increase staff numbers from 7,000 to 9,000 – that growth limits cost leverage. Moreover, R&D is now running at just 3% of sales, well below peer, CR Bard, at 9%. Can Coloplast realistically grow without more investment?

Whereas in 2008 Coloplast had lots of scope to improve profitability it is now at or very near peak. At current levels of profitability if Coloplast returns 100% of the cash it generates back to its shareholders all you get is a 2.6% return. That is a disappointing return, and hugely vulnerable to any rise in interest rates or deterioration in profitability.

All of Europe’s nifty fifty have similar characteristics. L’Oreal is reporting record high margins across all its regions but it is also spending the least (as a percent of revenues) on advertising in more than a decade. Inditex is valued at EUR 14mln per store, twice its historic average, even though profit growth at its Zara brand has stalled.

They are all excellent businesses. However the stocks of many high quality European businesses are going to have future returns roughly the same as the dismal return in bonds, and that’s if they can sustain record profitability. These companies are not a better alternative to bonds but rather a risky equivalent.

If you want to beat the low returns on offer in bonds look elsewhere, either to companies with assets that are earning very depressed profits, like HSBC or Vallourec, companies where investor expectations have reset much lower, like IBM or Coach, and companies where management has a realistic, achievable and public plan to improve profitability, like IMI