“What if the cost of capital never rises again?”

I first saw this question a few months back in a post on The Reformed Broker. I’m also putting together a presentation on the implications of this for one of my economics courses this semester, so I figure I might as well write about it here.

The cost of capital (in the sense in which we are referring to it), is the cost of borrowing. From the perspective of a business, it is imperative that a project returns more than what the cost of borrowing the capital to finance those operations was. For investors, the cost of capital is a significant number also as it affects the value of a business. For this piece, part of what we’re referring to is the “cheapness” of capital. We’re thinking about the cost of capital not as a hurdle rate, but plainly the rate at which long-term borrowing is taking place right now, which can be observed through long-term interest rates.

Today, the effective federal funds rate (see chart below) is at 2.13%. While the Fed has raised interest rates since dropping them to effectively 0% following the Great Recession, it’s been an uphill battle getting them back up. In 2019, we’ve already seen two 25 bps cuts and interest rates are now sitting in a range of 1.75 to 2.00%. While the recent cuts have been an effort to continue fueling economic expansion amidst recession fears and global uncertainty, the Federal Reserve has not hinted at any further cuts for 2019 — a wise move in my opinion. Gotta have ammunition if things actually do end up hitting the fan.

So what are the implications of all this cheap money circulating in markets and the economy? For starters, brand and intellectual property are valued higher than physical assets (book value). When the cost of capital is low, brand and intellectual property are weapons and physical assets are not because they aren’t costly to replace in this environment. Brand and intellectual property are costly to replace…in any environment.

Here are a few examples of how this has played out in markets recently:

  • WeWork’s (NOT profitable) original $47B valuation versus IWG’s (Profitable, more space, more members, more locations) $3.7B valuation.
  • Deep red IPOs of unicorn companies such as SNAP, UBER, and LYFT – each of which are NOT profitable and also touted mind-boggling valuations pre-IPO.
  • BYND, which touts a market capitalization of 8.83B and trades at the following multiples: Forward P/E (540.74x), Price/Sales (53.17x), EV/Revenue (52.63x). The catch? Beyond Meat isn’t profitable either.

Not to jab at any of these companies or be overly pessimistic, but there’s no reason to be surprised at why WeWork has basically indefinitely delayed its IPO and why all of these other companies have seen their stock prices drop dramatically since becoming publicly traded. Whether its business model, huge growth expectations, or market euphoria – something is amiss and the results clearly show it.

From the article I referenced:

In the battle for capital right now, the brands and intangibles and user bases and networks are winning by a landslide against the things that used to be important. And the companies that are rich in those old fashioned things, like Walmart, Disney and McDonalds, are spending all of their time and attention to transform themselves into the spitting image of their upstart competitors. Disney wants to look like Netflix, Walmart wants to retail like Amazon, McDonalds wants to be as habit-forming and celebrated for its freshness as its former protege Chipotle is. Goldman Sachs wants to grow up to be BlackRock. And in emulating these younger models, they hope, their multiples will soon be following suit. And as for those stodgy old stalwarts of the 20th century that aren’t pursuing this transformation…it remains to be seen whether the rusty old assets they do possess will ever matter to investors ever again.

Is this the new normal? I don’t know. Neither you, me, or the world’s greatest economists can pin down where long-term interest rates are headed. One thing is certain though. It’ll be an extremely interesting future if the cost of capital stays as low as it is. Imagine the ideas and businesses that can be created when it costs nearly nothing to finance a business. Imagine what that means for valuations, which already tend to be high during periods of lower interest rates. That’s both a promising and scary future for the markets.

My best bet is that we’re going to be in a period of low rates for the next 20+ years. It’s hard to put a timestamp on an assertion like that, so take my timeline with a grain of salt. Nonetheless, low rates (and potentially the growing usage of negative interest rates) will be an interesting development to keep our eyes on. When it comes to negative interest rates, this time might actually be different.

-Cole.

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