Nygren: Stocks Still Attractive

Have rising bond yields made stocks less attractive? No, says top fund manager Bill Nygren of Oakmark.

In his second-quarter client letter, Nygren discusses the “Dividend Discount Model” his firm uses to assess stock values. According to the model (one of several Oakmark uses), the combination of dividend yield and dividend growth must be equal to an investor’s required return. The required return, he says, is a combination of a “risk-free asset” (Nygren uses the 7-year Treasury) and a risk premium. “The premise of the Dividend Discount Model is that a rational investor must get paid to accept the risk inherent in owning a stock rather than owning a risk-free bond,” he says.

Oakmark’s historical analysis finds that equity investors usually demand that an average stock earn about five percentage points more in expected return than the 7-year Treasury, Nygren says. So if the bond yield is 4%, the combination of dividend yield and dividend growth should be at least 9%. Currently, the 7-year Treasury is just below 2%.

“For four years we have been saying that bond prices are not being set by long-term investors, so instead of using the actual interest rate, we’ve used a 3% floor,” Nygren says. “This way, our equity valuation estimates have not inflated to what we see as unsustainably high levels. Instead, we believe that stocks were, and continue to be, somewhat undervalued relative to a seven-year government bond that yields 3%.  Even after the recent increase in interest rates, the seven-year has moved only a little more than halfway back toward our floor of 3%.  So the declining bond market has not at all dimmed our enthusiasm for equities.  We are effectively already factoring in the assumption that rates continue their upward march until the seven-year hits 3%.”

Nygren says another big hit to the bond market would have to occur before it would potentially lower Oakmark’s estimate of equity values. “Rather than panicking about higher interest rates, we are encouraged that investors, rather than traders, are again buying bonds,” he says. “And as investors regain control of the bond market, we wouldn’t be surprised to see rates continue to rise somewhat. Actually, for some of our stocks — especially the financials — we expect that their earnings will also increase as rates rise. So, we continue to believe that equities are attractively priced relative to both their own long-term history and to the opportunities available in the bond market.”