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Classic Bernstein 5 — What’s a Thing Worth?

Posted: Mon May 09, 2016 4:41 pm
by SimpleGift
PREFACE: This is the fifth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?
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Fundamental to understanding investments (and several Classic Bernstein topics to come) is the concept of discounting. In short, a future return is worth considerably less in present value than an immediate return. Thus, the value of a future return must be discounted to the present by the appropriate rate of interest. This post distills one of Mr. Bernstein’s early articles on the subject, which is itself condensed from the classic 1930 book by Irving Fisher, The Theory of Interest. To pursue this topic in more detail, these original sources are highly recommended!

The Basics: The value of any financial investment is simply the present value of its future income stream. Only income-producing assets, such as stocks, bonds or commercial real estate, are truly investments. Granted, many stocks do not have current earnings or produce dividends — but any stock price above zero suggests that some investors believe it may pay out in the future, if only from the sale of its assets. The acquisition of non-income producing assets, such as rare coins or fine paintings, is considered a speculation, as one’s return is entirely dependent on someone paying a higher price for them later.

The Example: To show discounting in the simplest way, Mr. Bernstein uses an example from Fisher that, while a bit quaint, serves the purpose: the valuation of a mine and a forest. (Modern readers can substitute value stocks for the mine and growth stocks for the forest). The mine produces ore for a relatively brief time, with the highest returns in the first years, which gradually fall to zero as it’s played out (see table at left below). The newly planted forest provides no return in its early years, but then gradually increases its returns over time.
The Results: Which is the better investment? It all depends on the discount rate (also known as the interest rate). Since a dollar of income next year is worth less to us than a dollar today, and a dollar in 10 years is worth even less to us today, each year’s income from the mine and the forest needs to be discounted back to the present day. (For a very readable guide to how to make these calculations, see Mr. Bernstein’s 2002 book, The Four Pillars of Investing , Chapter 2). The chart above already plots for us the present day value of the mine and forest at various discount rates.

What observations would Mr. Bernstein like us to make from this chart and table?
  • a) First, note how an increase in the discount rate (interest rate) decreases the present value of both investments, since in all cases this decreases the value of future income.

    b) Next, note how the mine (value stock) does best in a high interest rate environment, because its annual returns are “front-loaded,” largely escaping the increasingly corrosive effect of the high discount rate in later years.

    c) Last, note how a low interest rate environment favors the “back-loaded” long-term returns of the forest (growth stock).
Thoughts?

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 12:05 am
by ANC
Simplegift,

This one is based on manufactured data that is much cleaner than real-world data and the trade-offs seem obvious. At first glance, there is little to discuss.

One factor to add is what if we're wrong on the interest rate projections. The answer depends on the amount and skewness which may not be knowable. A first-blush heuristic may be to opt for the value stock as you get your money earlier.

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 12:40 am
by saltycaper
Simplegift wrote:b) Next, note how the mine (value stock) does best in a high interest rate environment, because its annual returns are “front-loaded,” largely escaping the increasingly corrosive effect of the high discount rate in later years.
I guess this assumes neither has any debt to service? Realistically, the mine owners probably had to borrow a tidy sum to start operating and took a couple-few years to start earning a profit. If value companies tend to have more debt (right?), surely that must come into play.

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 12:48 am
by diyfp
Anyone know of any data that shows this (value doing better in high interest rate environments)?

I vaguely remember looking for correlation between HML and the risk-free rate (Fama-French data) and not finding much of one...

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 12:56 am
by SimpleGift
diyfp wrote:Anyone know of any data that shows this (value doing better in high interest rate environments)?
Actually, this is the very next topic in the Classic Bernstein series. In his analysis, Mr. Bernstein looked at the performance of value stocks in various inflation environments over the course of the 20th century, using the Fama-French data. Stay tuned!

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 1:04 am
by SimpleGift
ANC wrote:This one is based on manufactured data that is much cleaner than real-world data and the trade-offs seem obvious. At first glance, there is little to discuss.
Agree that there might not be much to discuss with this post, since it involves a simple hypothetical example with made-up data. However, Mr. Bernstein relies heavily on this concept of discounting in other investigations that are coming later in the series — each using real world data to analyze interesting investing puzzles.

So apologies for the rather bookish post, but hopefully its future value will be revealed soon enough — and you won’t discount the future value of these academic concepts too heavily at the present time. :wink:

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 1:43 am
by raven15
One thing I'd like to point out is that discount rate is not necessarily the same as interest rate. It is also/instead a measure of how important or risky the future is relative to the present. As an example, in 2012 I did some consulting work for an actual gold mine. They selected projects in a way that implied a discount rate of around 30% or more, meaning they had no confidence in the future whatsoever (and gold prices plummeted the following year). However, the interest rates most people experienced at the time were closer to 0.

Generally a low discount rate implies a high confidence of continued existence in the future, and that money in the future will be similarly useful to the present. If future existence or future usefulness of money is highly questionable then the future is greatly discounted, i.e. you want the money right now because tomorrow may not come. An individual's discount rate might be much higher than interest rates in general, which probably explains a lot of things in society, like lotteries and low retirement savings.

In other words most Americans prefer a gold mine, because they don't want to sit around and wait a few decades for the trees to grow.

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 8:26 am
by Random Walker
The market prices risk; more risk, lower price, higher future expected returns. Less risk, higher price, lower expected returns.

Dave

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 3:25 pm
by ANC
raven15 wrote: In other words most Americans prefer a gold mine, because they don't want to sit around and wait a few decades for the trees to grow.
My way of looking at this is that most people use a payback-period analysis and not present value. This, however, does not reconcile with Bernstein's finding that people overpay for growth stocks. Perhaps the payback-period investors have more in fixed income.

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 3:59 pm
by Optimistic
Simplegift - Would you mind putting links to the first 4 posts in the original post in this thread (and subsequent threads)?

Thanks!

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Tue May 10, 2016 4:22 pm
by SimpleGift
Optimistic wrote:Simplegift - Would you mind putting links to the first 4 posts in the original post in this thread (and subsequent threads)?
I started out doing that for each post in the series, but decided it would soon become cumbersome as the number of posts in the series grew. Instead, with the efficiency of the search engine up in the top right corner of the Forum page, I reasoned that folks could just enter "Classic Bernstein" and get the full list of series posts in seconds.

I'm open to re-examining this decision, if the search engine approach proves unreliable or unworkable.

LATER EDITED TO ADD: I've decided to take your suggestion, Optimistic, as the search engine is apparently not listing all the posts in the series (for some strange reason). Thus, I've now added links to all the previous posts and will do so in subsequent threads. Thanks for the idea.

Re: Classic Bernstein 5 — What’s a Thing Worth?

Posted: Sun May 29, 2016 1:27 pm
by LadyGeek
A complete list of Simplegift's series is now in the wiki: Classic Bernstein