Investors crave certainty, but they are also highly prone to misprice her. Since Britain voted to leave the EU the return offered by developed market government debt has tumbled to new lows. The US 30-year treasury yield is down to nearly two percent, whilst the UK government equivalent is now below 1.6%. In other words, jittery fund managers are paying 50 to 60 times the gross annual return of these 30-bonds, to the comfort of knowing they will get their money back at the end, albeit having likely suffered a loss in real terms.
It seems that the market is willing to offer these three decades of lending to these governments at such a low price because it is effectively discounting a very painful period of minimal or nonexistent growth and inflation. Conventional wisdom has it that there are very few alternatives to this low yielding debt right now. Stocks, this argument goes, are both very richly valued and actually far riskier. But in fact, stocks in high quality companies with a long history of growing their cash flows still look quite cheap on certain historical measures. This suggests that investors are significantly mispricing the total certainty they belief government debt provides them with, compared with the reasonable certainty offered by shares in consistently growing businesses.
One example are shares in Nestle, a 150-year old company that has survived multiple wars and recessions and grown its profits consistently during these crises. They are currently trading at a price to free cash flow ratio of 22 times, weighted against a 30-year average of 25 times. This multiple converts to a cash yield of 4.4%, which has to be balanced against the fact that Nestlé’s 10-year debt is currently offering a negative yield, meaning that buyers are paying the company to lend it money. More importantly, Nestle has grown its free cash flow per basic share at a compounded annual rate of 9% over the last 30 years. Because, unlike bonds, high quality companies actually compound their intrinsic value over time. This compounding provides a margin of safety, even when a seemingly high multiple is paid. It may not be an absolute certainty that Nestle continues to grow consistently forever, but its shares, and those in international franchises with a similar record, appear a bargain compared with the rest of the market.