WisdomTree Minds on the Markets
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Minds on the Markets
Archive: October 30, 2023
The Confused Stock Market Will Not Be Confused about Profitless Stocks
Mean reversion, where art thou?
Using Ken French’s data library, we tabulated the relative performance over the last 20 years of companies that paid no dividends and the 20% of companies that paid the highest dividends. Because of so many years of general market dominance by notorious non-payers such as Meta and Alphabet, the former outperformed by an annualized 2.7% in the two decades through September. That is the boldest outperformance by the 0% dividend cohort of any other such window from 1927 until the onset of COVID-19, including the 1980–2000 dot-com experience.
A question, yet unanswered, is whether the shock move in the 10-Year Treasury to 4.84% from sub-1% levels a couple years back will pose more of an obstacle to a low-yielding group like Tech than a dividend-heavy basket like Utilities.
The market hasn’t the foggiest idea. The S&P 500 reached a nearby peak of 4,607 on July 27 and has been in a grinding drift lower ever since, closing at 4,117 on Friday. Initially, one of the more punished groups was Utilities, which cratered as much as 16% at the worst of it, though that sector caught a relief rally for the bulk of October. Tech was and has been performing in line with the market, declining 9% to the market’s 10% fall.
That would seemingly settle the debate: higher rates are more loathed by so-called “yield sensitives,” code for big dividend payers like electric utilities, food companies and pharmaceuticals. If so, it is a tough pill to swallow for those who got in front of the bearish tape by sheltering in Big Tobacco, only to see their positions get smoked.
But stop right there, because trouble in yield plays is hardly the dominant theme of this correction. Look at the carnage inside the Russell 2000 Index. The problem there? Unprofitable firms, which comprise 28% of its market cap. That Index has been taken out this summer and fall, declining 15% since the market’s peak.
Discounted cash flow time. We will make this very simple. Suppose a business venture offers a single $100 cash flow in 10 years. Because this is a risky Russell 2000 growth stock, suppose our “old” calculus during the quantitative easing (QE) days was to take a 1% yield on the 10-Year Treasury and tack on a large equity risk premium, 700 basis points (bps), to come up with a discount rate of 8%. Discounting our lone distant cash flow, the stock was worth $46.32 in the easy money days.
Now, the Treasury yield is 4.84%. Add the same 700-bp equity risk premium on this unprofitable microcap. The discount rate: 11.84%. This stock is no longer worth $46.32; it’s worth $32.66.
All great in theory, but it’s cold comfort to anyone who was sheltering in dividend yielders, so-called “low duration” equities, who got taken out and shot with everyone else in August and September.
The market is sorting out the arithmetic of discounted cash flows but punishing everything. Sooner or later, it will have to face up to a new arithmetic: what happens to the balance sheets of the big debtors when old paper gets rolled into new issues which will potentially carry visibly elevated debt-servicing costs? For those in need of equity capital instead of debt, their next funding rounds are going to come with big internal rate of return (IRR) demands.
Maybe we don’t know if Tech will win or if Utilities will win, or that type of thing. Maybe all we “know” is that any company that couldn’t turn a profit in 2023 may not take kindly to a 5% interest rate world.
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