What’s Your Equity Duration?
Published: September 16, 2016
"Interest rates have nowhere to go but up!"
We have probably all become tired of hearing this comment over the past few years. While the Fed could increase rates later this year, interest rates across the curve could still stay low for a while longer. After all, the Fed only controls the short-term benchmark interest rate. But let’s assume for a moment that rates do find their way back to a more normal level. We’ve all thought about it and planned for it. If you manage a pension plan, you may have determined what the impact will be on your liabilities or bond portfolio. But have you given any thought to what could happen to your equities portfolio?
In other words, do you know your equity portfolio’s duration?
In theory, figuring out the duration of an equity portfolio is not that tricky. Whether one uses P/E ratios, EV/EBITDA or a discounted cash flow (DCF) method to get to the valuation of a stock, all of these approaches are essentially ways of discounting future cash flows to reach an intrinsic value. Essentially, just as the duration of a bond can be derived by discounting a bond’s cash flows at different interest rates (the duration being the impact on the value of the portfolio of a one per cent change in interest rates), the same can be done for a stock.
There are two primary reasons why determining the duration of an equity portfolio can be beneficial. The first is that you can use the equity duration figure to gain a sense of how much the portfolio could go down if interest rates increase by a set amount. For example, the last time we did this analysis, most of our equity portfolios had a duration of about 25. This means that the value of this portfolio could be expected to decline by about 25 per cent should interest rates increase by one per cent.
Now, there are a number of caveats and mitigating factors that apply here. The reason why rates are increasing will have a big influence on the degree by which the portfolio value changes. Typically, interest rates increase because the economy is doing better and inflation is picking up. If that’s the case, we would expect companies in the portfolio to perform better, everything else being equal (i.e., the portfolio may decline by less than 25 per cent). This also highlights the difference between cash flows from bonds which tend to be fixed and cash flows from equities which are highly variable.
The second reason for doing this analysis is that in today’s environment, where many stocks seem to be full or over-valued, investing in lower duration stocks can be a way of lowering the level of risk in a portfolio.
We currently believe that one of the main risks investors face is valuation risk. The impact of this could come to bear in two different ways: by having investors reassess their risk tolerances ‒ something that the prospect of a hard landing in China or other macro event may help trigger ‒ or by seeing interest rates increase. Both of these factors would increase the cost of funds for companies but also, and more significantly, increase the discount rate investors use to value investment opportunities. Investors readjusting their risk tolerances would lead to an increased equity risk premium while an interest rate hike would impact the risk free rate. Both ultimately increase the discount rate used to value stocks.
The good news is that a lot of companies have managed to reduce their duration by initiating or increasing stock buybacks or dividends (similar to a bond, the sooner cash gets returned to investors, the lower the duration of the investment). Another factor we consider is looking at when a company expects to earn its cash flows (i.e., a company that has long-term projects that will take a lot of time to ramp up before they produce cash flows will have a longer duration than a company that generates cash in the near term).
Whether you can or want to actively lower the duration of your equity portfolio, we believe that knowing what that duration is will help you be better prepared for an eventual normalization of interest rates and have a better grasp of an often misunderstood risk: valuation risk. If anything, having a discussion on this topic with your manager should provide great insight into the risks that are embedded in your portfolio.
Jean-Philippe Giguère (CFA, FSA, FCIA) is institutional portfolio manager at Mawer Investment Management Ltd.