November 28, 2016
Third Quarter 2016: Investment Perspective
If your eyes glaze over contemplating the miseries of sovereign real yields, consider for a moment the stock of Swiss food manufacturer Nestlé. Its current free cash flow yield is 4.40% — a healthy 500 basis point premium to the Swiss 10-year sovereign yield. So investors can pay the Swiss government 0.55% per annum to hold their capital and experience the added insult of a loss of real purchasing power. Or they can own a share of Nestlé’s free cash flow stream at an economic return of 4.40%. Assuming inflation is 1% and the company grows its free cash flow at 1% in real terms, your risky investment in Nestlé will outperform the risk-free by 7% per annum in real terms. If you have a long time horizon and reasonable risk aversion, it seems to be a compelling trade off. Not so fast, argue the interest rate hawks. You are deluded by central bank chicanery. The Swiss Government bond market is artificially distorted, and rates will normalize to 1.50%. In an instant you will lose 15% in your ‘risk free’ bonds. Worse, because you priced Nestlé on the basis of manipulated default free rates, you stand to lose your shirt in Nestlé stock. Nestlé shares would need to fall 30% to give the same risk premium. In a nutshell, that is the conundrum of the current rate environment.
On a quarterly basis, Hirtle Callaghan publishes our perspective on the current market. We have included the first page of that piece below. If you would like to receive the full perspective, please contact us.