Disclaimer: The info below here is not intended to be nor constitute financial advice or investment advice.
- My short backdrop environment while investing in securities from fixed-income and stocks.
- Inflation and interest rate factors in the U.S. market pull down the sentiments.
- The importance of valuation determines the attractiveness of equity.
- Investment in Malaysia with fixed income securities.
Based on the survey I asked about my friends, the salary for engineers at Penang has increased slightly in response to the demand for high-tech industries offered at Bayan Lepas. Prices for condo properties at KL had stagnated since 2012 although residential on landed properties experienced uptake at Johor’s neighboring Singapore — software, semiconductor, and tech employees. Before this REIT (Real Estate Investment Trust), properties experienced a sharp downturn while income was affected by COVID-19. Rental house prices had stagnated since 2020, however, local analysts and bloggers believed the rental price will recover eventually with the inflation play next year in early 2023. The industrial segment put a spin on this story, my local broker at RHB Research reported the fast expansion of e-commerce, needs for warehousing space, value chain storage and logistics, etc.
Prelude to the story
In tandem, the U.S. government Federal Reserves (Fed) took a substantial monetary stimulus in response to the COVID-19 infection rate in early 2020 that has tremendously impacted global economies. In response to this measure, the money supply chain has increased to create bank reserves, the interest rate has been reduced to stimulate, increased of cash reserves to meet central bank requirements, reduction of borrowing costs to 25 basis points above zero.
Malaysia COVID-19 entered an endemic phase in April as stores, stalls, and kiosks do not need to provide QR codes. Biz owners, shopping malls, wholesale markets, and bazaars (“Pasar Malam” colloquially) may still require QR codes at the main entrance. Outdoor areas, areas without crowds, and mass gatherings (i.e., recreational areas) are exempted from this guideline.
The price at my dining, food centers, hawker’s places, and shopping outlets have been steadily increased considerably to as high as 30 percent (albeit by my informal measure, TheStar survey). Prices for foods and essential goods available on the morning market have been on an ever-increasing trend although at a lower rate compare to dining.
US market 2022
The sudden surge in goods and services has considerably reduced consumers’ purchasing power. From a historical perspective, prices of goods and services had been inflated from the 70s to the peak in 1981 (measured in USD) putting a pause on the economic development. As COVID-19 vaccination becomes more readily available worldwide, cooling down the economic engine activity may sharpen the risk of recession. The current SPY ETF index (Exchange Traded Fund) retracted to the level at the beginning of mid-2021, a year earlier, as the market anticipated looming negative factors, and pessimism is mounting.
Based on Barron’s estimation see a range-bound between 2.75%-3.25% toward the end of 2022.
That means the federal-funds rate could stand at between 2.75% and 3% by Christmas, a full percentage point higher than the median anticipated by policymakers in March, and a sharp rise from close to zero in January.
The Fed is projected will see six more rate hikes this year 25 to 50 basis points each hike. Borrowing costs will increase in response to the rate hike.
Analysts at Morgan Stanley point out that over the past few weeks the circa 70 basis-point rises in U.S. real yields — which subtract inflation expectations from a bond’s nominal yield — appear to have had a limited impact on global equities.
MS believed inflation has peaked, the Fed may hike interest rates in the consecutive months despite growing revenue by the companies, turning to investors who are attracted by fixed-income yielders.
GS reported a 35% chance of a recession in 2024 resulting in a lower short-term equities market. Tech sectors were impacted by lower than average returns due to the surge in inflation accumulated in the previous year, the current inflation level. Bond is set to deliver a historic interest of 9% annualized return starting May 2022.
As a result, we now see the odds of a recession as roughly 15% in the next 12 months and 35% within the next 24 months,” said Jan Hatzius, Goldman Sachs chief economist, in a new note to clients.
Employment data remained robust as companies at my colleagues in FTZ and U.S. are recruiting to build their company’s arsenals. This led me to believe that the market is on a soft recovery play as the companies overheated at the near end of the 2021s.
Interest rate hikes may interplay with the stock weighing down the value of equity, lower P/E ratios, and lower sentiments in the stock market. Investors may be tempted to find a sheltered place that could offer them fixed income securities without the gyration in the stock market. For example, a stock with a high WACC above 10% can mean the difference between a buy or a no-buy on a stock or stock versus fixed income securities similarly.
WACC — Weighted average cost of capital
I am new to accounting literature and the acronym of the Whack factor or get Whacked by the tech analysts. Financial accounting or WACC is useful to evaluate investment opportunities.
The rise of treasury yield is used to price domestic debts, an influential factor that will lead to the rise in consumer interest rate, impacting the valuation of stocks. Equity assets held by investors could be fallen from several percentage points to as much as halves of the equity value —from minor valuation change to violent abruption in the equity market. Investors decided to move out of their equities to safer haven assets, e.g. bonds and government securities funds.
WACC attempted to capture the value of an asset in a series of equations. Slight tinkering on the WACC numbers, a percentage point change in ratio, could mean a world difference in our valuation analysis, from buying to not-buy, from haven to fire sales in equity assets.
Veteran investors preferred complexity over correctness which could be captured in a series of equations to evaluate by financial analysts. The WACC formulation is popularly preferred by academicians and analysts on Wall Street.
Cost of Debt
In the remarks below, we may need to decode this formulation based on GuruFocus’s computation for INTC (Intel). Cost of Debt can be computed as a direct proportion of Interest Expenses over Debt. Interest Expenses can be found in the Income Statement and Debt in the Balance Sheet.
3. Cost of Debt:
GuruFocus uses last fiscal year end Interest Expense divided by the latest two-year average debt to get the simplified cost of debt.
As of Dec. 2021, Intel’s interest expense (positive number) was $597 Mil. Its total Book Value of Debt (D) is $37251 Mil.
Cost of Debt = 597 / 37251 = 1.6026%.
Does more debt reduce risk factors? Interest expense over debt payment of ~1.6% may make some sense in prior years in 2021, however, the Fed is projecting to increase the interest rate in the current year. However, I am not certain about the weight of debt at the 16 percent which is expressed as debt over the sum of equity and debt.
4. Multiply by one minus Average Tax Rate:
GuruFocus uses the latest two-year average tax rate to do the calculation. The calculated average tax rate is limited to between 0% and 100%. If the calculated average tax rate is higher than 100%, it is set to 100%. If the calculated average tax rate is less than 0%, it is set to 0%.
The latest Two-year Average Tax Rate is 12.56%.
Based on the WACC formula, the pre-tax cost of debt number must be multiplied by the tax shield (1 — t) because interest expense is a tax-deductible item in most countries. Companies with high amounts of debt can sometimes have a relatively low WACC. Companies with lower WACC may lead to higher valuations that can mislead investors into attractive investments.
To anyone who pays taxes, a high taxation rate environment may reduce the profitability of the entity for our logical deduction.
1. Weights:
Generally speaking, a company’s assets are financed by debt and equity. We need to calculate the weight of equity and the weight of debt.
The market value of equity (E) is also called “Market Cap”. As of today, Intel’s market capitalization (E) is $191514.519 Mil.
The market value of debt is typically difficult to calculate, therefore, GuruFocus uses book value of debt (D) to do the calculation. It is simplified by adding the latest two-year average Short-Term Debt & Capital Lease Obligation and Long-Term Debt & Capital Lease Obligation together. As of Dec. 2021, Intel’s latest two-year average Short-Term Debt & Capital Lease Obligation was $3547.5 Mil and its latest two-year average Long-Term Debt & Capital Lease Obligation was $33703.5 Mil. The total Book Value of Debt (D) is $37251 Mil.
a) weight of equity = E / (E + D) = 191514.519 / (191514.519 + 37251) = 0.8372
b) weight of debt = D / (E + D) = 37251 / (191514.519 + 37251) = 0.1628
Under rating, the weight of debt parameter may result in over budgeting Capex (Capital Expenditures) forecast toward the ensuing years. INTC has been forecasted to build a few more fab plants across Oregon, Arizona, Israel, Ireland, Germany, and Italy. A large portion of assets (Equity = Assets minus Liabilities) was contributed by Property, Plant, and Equipment approximately $150B, Goodwill spent $27B through the acquisition of companies by the annual end of 2021. Veteran investors preferred Free Cash Flow over Net Profit, Accrual vs Cash basis accounting as their favorite metric over accounting profit issues, and fake accounting scandals in the last decade.
Beta of Asset
CAPM model provides a theoretical framework that measures the Cost of equity capital of a company based on a basket of stocks (NASDAQ and NYSE), the riskiness of the equity, and volatility factors that may fluctuate in the market. CAPM model assumes the rationality of investors they will correct any mispriced equity quickly. The model was originally developed by economic scientists in the 60s.
2. Cost of Equity:
GuruFocus uses Capital Asset Pricing Model (CAPM) to calculate the required rate of return. The formula is:
Cost of Equity = Risk-Free Rate of Return + Beta of Asset * (Expected Return of the Market — Risk-Free Rate of Return)
a) GuruFocus uses 10-Year Treasury Constant Maturity Rate as the risk-free rate. It is updated daily. The current risk-free rate is 2.82100000%. Please go to Economic Indicators page for more information. Please note that we use the 10-Year Treasury Constant Maturity Rate of the country/region where the company is headquartered. If the data for that country/region is not available, then we will use the 10-Year Treasury Constant Maturity Rate of the United States as default.
b) Beta is the sensitivity of the expected excess asset returns to the expected excess market returns. Intel’s beta is 0.60.
c) (Expected Return of the Market — Risk-Free Rate of Return) is also called market premium. GuruFocus requires the market premium to be 6%.
Cost of Equity = 2.82100000% + 0.60 * 6% = 6.421%
Gurufocus computed INTC’s beta to 0.60 as above. For comparison purposes, Meta’s beta is 1.41 shows larger than one implying riskier equity than INTC. Beta lesser than 1 implies INTC will move along the overall market. Indeed Meta dived over 40% delivering a weak Q4'21 quarterly result due to over-economic optimism by investors before the downfall implying that INTC may provide better stable stability.
WACC=E / (E + D)*Cost of Equity+D / (E + D)*Cost of Debt*(1 — Tax Rate)
= 0.8372*6.421%+0.1628*1.6026%*(1–12.56%)
= 5.6%
TSMC’s WACC is 7.79%. TSMC made semiconductor wafers similar to INTC for a better comparison group than Meta, which was born from a start-up root. The higher interest rate proposed by the Fed in 2022 may make INTC or TSMC, in this group under my evaluation, much more profitable than Meta. Perhaps, WACC is not as useful for investors as I anticipated.
Nice derivation printed out by Gurufocus which allows us to introspect the formula used to arrive at the conclusive numbers.
WACC and Warren Buffett
Buffett’s opinions differed on the WACC subject rather he preferred complexity over the correctness of the mathematician. Inflation is no mere fancy by the math wiz, it will lead to an increased interest rate in the subsequent coming months. Everyone succumbs to interest rates before us.
However, I do not think Buffett considers a default premium for the firm. WACC formula indicates the interest rate paid by the firm equal to the risk-free rate plus the default premium for the firm. Buffett accepted the U.S. Treasury rate in his 1998 Annual Meeting out for certainty, to weed out the poor investment for the superior investment.
“We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”
He recommends the use of a Margin of safety for investors to buffer against gyration up or downswing in our valuation, similar to many engineering disciplines.
“[When investing] you do not it cut close. That is what Benjamin
Graham meant by having a margin of safety. You don’t try and buy
a business worth $83 million for $80 million. You leave yourself
an enormous margin. When you build a bridge, you insist it can
carry 30,000 pounds, but you only drive 10,000 pound trucks across
it. And that same principle works in investing. “
He confessed that he doesn’t use any rate at all! He could do the calculation at the back of the envelope? Guesstimate calculation! See SeekingAlpha article.
My opinion about the bond sees below. DCF (Discounted Cash Flow analysis) is a useful tool that is usually done on a spreadsheet to evaluate the assets.
Buffett- “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond — the question is, how much higher?”
Munger- “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”
An alternative valuation method to WACC is APV (Adjusted Present Value) which uses Unlevered cost of capital to discount Free cash flow, however, the article appears slightly outdated. Academicians and Wall Street analysts preferred WACC over other methods of valuation despite the inaccurate numbers mentioned here above in this article.
To get around my valuation problem, I decided to affix it from 10.0% low to 12.5% high, accounting for the current inflation downtrend toward the end of 2023, until the economy recovered.
Malaysia interest rate
Based on Milton Friedman’s theory about his monetarist view of inflation: -
Inflation is always and everywhere a monetary phenomenon
Milton Friedman was an economist and statistician who won the Nobel Memorial Prize.
The general availability of the COVID-19 vaccine following monetary stimulus by the U.S. led to an increase in consumer demands for goods and services. However, the suppliers could not supply them enough due to the inflated prices and goods. Prompting the factories to demand higher wages, and hiring more workers resulted in the generally increased price level by the producers that stem from artificial money expansion. An example of this “wage-price” spiral can be seen at an event in Turkey.
Malaysia was badly hit by the last pandemic affecting predominantly hawkers food stalls, hoteliers, small-cap, and large-cap companies in Bursa. However, tech companies enjoyed some breeze relief from the grasp of the pandemic. Malaysia’s central bank decided to wait until the third quarter before raising interest rates from a record low to support an uneven economic recovery: -
The central bank was expected to hike rates to 2.00% in the third quarter, based on the median view, with half the 18 economists polled expecting that rate. Five expect rates to reach 2.25% and four expect no change by end-September.
Rental reversion remained intact despite the retail sales have improved considerably since the last pandemic. REIT or housing properties have stagnated although they foresee a gradual recovery as international borders reopened. Apart from REIT or housing properties, industrial properties foresee a strong demand for warehousing and logistic assets. Observers of the REIT market see the second half of 2023 would seem attractive to the sellers or rental.
Ringgit value slid in response to Fed’s recent decision to raise interest rates by 0.50% to 1.00%, a weaker fundamental value in the foreign exchange rate from MYR to USD conversion rate. My brokerage thinks it will likely be traded along with the range towards RM 4.50 due to the gloomy outlook mentioned in this article. However, it reminds me that currency trading remained to be speculative traders apart from the fundamental changes by the Fed, Ukraine invasion, shortages, etc.
For individual dividend income earners, retirees, and employed, KWSP provided 6.10% in 2021 amidst the devaluation in the currency market. The last highest record was in 2017 and 2018, 6.90% and 6.15% afforded by KWSP. KWSP remained dominant for stable income dividends who do not want the gyration by the stock market nor follow news development. Alternative to stable dividend earners, citizens could purchase bonds issued by MGS for 7 years at MYR 2 mil although at a lower rate that can be afforded by KWSP. I think the bonds market in Malaysia could pull insurance and asset manager alike. Individuals might be able to purchase an I Bond with Social Security Number in the U.S. that could provide above 9.62% based on this website.
Conclusion
Interest rate hikes from 2022 to early 2023 announcement by the Fed officials are useful however they cannot be precise. An interest rate hike may raise the price of equity based on WACC, APV, or rules of thumb computation that may affect the desirability of an asset. Attempt to forecast interest rates usually end up in futility said Peter Lynch in the video below: -
… and uh so you can take advantage of the volatility market if you understand what you own so I think that’s the key
The ability to predict the equity price of a stock and the maths are beyond my comprehension, unfortunately, rather a ballpark approximation. Nevertheless, it is still important to determine the price of equity and the allocation of capital. Finally, I concluded by making a case for fixed-income securities in Malaysia as opposed to investing in stocks in the U.S.
