Practical analysis for investment professionals
15 June 2015

The Little Worm That Is Destroying Capitalism

In response to the Great Recession, central banks continue to engage in massive monetary stimulus to artificially depress the costs of capital. Many commentators have expressed concerns (and I concur) about the inflationary forces they believe must naturally be building up because of this stimulus. Yet, very few commentators have discussed the consequential little worm that is destroying capitalism, and the mindset thus birthed.

Costs of Capital

Generations of business schools have taught — and business leaders have implemented — capital budgeting philosophies based on expected rates of returns and weighted average cost of capital (WACC). First, cash flows over a time horizon are estimated for a proposed project. On the positive cash-flow side, these may include additional revenues created or future expenses saved. Either way, there is some benefit to a business of the proposed project. Netted against these benefits are the negative cash flows — the expenses — that are expected to be incurred to implement the project. Next, the net flows over time are discounted by the WACC,  and the assumed risks of successfully implementing the project are built into this discount rate. If the net present value (NPV) of this calculation is positive, then businesses are supposed to proceed with the project. Still, others prefer to compare their expectations for internal rate of return (IRR) to the WACC. Either way, the process is the same.

The Little Worm

But this entire framework has a problem — the little worm that is destroying capitalism, albeit slowly. Namely, in calculating cost of debt and cost of equity for businesses, market-based rates are used, and with the misnamed “risk-free rate” serving as the root of all other costs of capital. What happens though when central banks’ loose monetary policy creates too much capital and artificially holds down root costs of capital? Companies adjust their required rates of return down, too. In fact, one could argue that this is a principal reason for why central banks are holding root costs of capital so low: to spur business investment.

Yet when WACC is held artificially low, many projects are accepted that previously would never have been considered viable under normal circumstances. Put another way, the problem is using relative values — not absolute values — in calculating costs of capital. Examples of such projects providing marginal benefits are: improving financial reporting systems through better information technology, minor tweaks to supply chain logistics, cutting back on marketing or increasing low-cost advertising (like social media), “rationalization” of head count, holding average wages as low as possible, squeezing suppliers a little bit, not repatriating earnings to stave off taxation, refinancing rather than retiring debts, and the share buyback that is insensitive to a company’s current stock price. I could go on.

It is not that these marginal WACC projects are unworthy and shouldn’t be done, it is that the lifeblood of capitalism is creative destruction. It is fiery and intense. Capitalism is supposed to be more like a volcano than a hot plate keeping the coffee warm!

Evidence that the worm is eating away at capitalism is that revenues continue to grow much more slowly than do earnings per share (EPS). Furthermore, revenues continue to miss consensus estimates even though EPS continue to beat estimates. Also, EPS continue to grow so quickly due mostly to a shrinking denominator (i.e., big share buybacks). Ask yourself: When was the last time you heard genuine risk-taking behavior on the part of your portfolio of businesses? I think you will agree that only a handful of companies are engaged in proper game-changing capitalistic risk taking.

Normalized Cost of Capital

In the developed nations, I estimate a normalized long-term project after-tax WACC of around 6.5%, versus an estimated late 2014 WACC of only 3.0%. Even if you disagree with my estimates, I believe if you calculate your own, you will find that current costs of capital are about less than half of a normalized figure. That means you should expect at least 100% more projects being approved than under normal cost of capital scenarios. Yet this high figure may actually understate the number of excess projects being funded. This is because as cost of capital asymptotically approaches zero (i.e., “to negative nominal yields and beyond!”), the actual number of projects thought of as viable may follow a power law distribution instead of behaving linearly. In other words, businesses are currently in the process of destroying what was, once upon a time, a precious resource to be conserved: capital.

A Remedy?

If you agree with me, I propose, as a simple remedy, that costs of capital for a business begin to be evaluated on an absolute, normalized basis, rather than on a relative basis. And, I would add, treating externalities as free/not considering economic, social, and governance (ESG) is not going to cut it either. As a shareholder — or prospective shareholder — you do not need to wait for a company to engage in this behavior. Instead, you can begin to use normalized costs of capital in your own estimates of fair value. This may shrink your universe of investible assets, so be wary of diversification being worse.

Fear the Worm

My big fear is that even once costs of capital begin to rise/normalize, a generation of gutless business leaders is being hatched in the current gutless business culture. In short, artificially low costs of capital are eroding the capitalist’s risk-taking, return-generating mindset. Yikes! In conclusion, which company would you rather invest in: the one using normalized costs of capital in capital budgeting, or the company just using traditional methods? Thought so!

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/afe207

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor. Previously, Jason was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. He holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

29 thoughts on “The Little Worm That Is Destroying Capitalism”

  1. HIREN SHAH says:

    The article was awesome.Connecting Corporate Finance with the present artificially low interest rates simply gave a different perspective altogether.

    1. Hello Hiren,

      Thank you for your thoughtful comments. I am glad you enjoyed the piece.

      Yours, in service,

      Jason

  2. Per Kurowski says:

    It is worse. The usual proxy for the risk-free rate US treasuries, are in effect being subsidized by means of bank regulations that favor government borrowings.

    http://subprimeregulations.blogspot.com/2013/01/the-subsidized-risk-free-rate.html

    1. Hello PK,

      Thank you for weighing in and for providing your link.

      Yours, in service,

      Jason

  3. Darin says:

    Hey Jason,

    Interesting post…stands in contrast to some research I’ve read recently (James Montier — The Idolatry of Interest Rates Part 1). In particular, the misconception that hurdle rates for corporate investment projects declines in tandem with interest rates. I won’t bother to quote it word for word (you can download it for free from GMO’s site), but I would be interested to hear your thoughts after consolidating this information.

    1. Hello Darin,

      Thank you for the link – I am a fan of James’ writings and may take a look. Right now my stack of reading is measured in the tens of centimeter category : ) Not having read what GMO has published I cannot speak directly to it. However, I would venture that the context of their piece and my piece are slightly different. I am focusing at the corporate finance level, and I am guessing GMO is looking at the global financial industry. There is certainly idolatry of interest rates in finance. But that makes sense since most of finance is transaction oriented and because interest rates set the price of most transactions, directly or indirectly.

      Yours in service,

      Jason

  4. Umed says:

    What a great article!

    I can’t help but think if the “gutless” managers are such by their own choice or as a response to the external stimulae (e.g. lower than usual interest rates) that change the competitive landscape.

    If latter, then there is no reason to believe the gutless behavior would persist. Businesses adapt after all…

    1. Hello Umed,

      It is nice to have an article called ‘great’ – thank you!

      You make a valid and intelligent point. Interest rates can drive capital investment behavior, but I believe capitalist competition drives it more. Ideally, I believe competition is the driver of innovation, rather than interest rates. Unfortunately, I can think of only one good example of competition leading to interesting capitalist developments: the iPhone has driven innovation from Samsung, for example. But I am hard-pressed to think of significant others. I am anxious that a generation of business leaders is close to institutionalizing a mindset of investing in marginal capital projects.

      Also, Darin (see question above) makes the point about interest rate idolatry via GMO’s Montier…there was a time in this capitalist’s life when companies feared getting their next project wrong because they feared their competition would outpace them. Ideally companies have as their axis their competition, and not the policies of central banks.

      Thank you for contributing meaningfully to the discussion!

      Yours, in service,

      Jason

  5. Bob Landry says:

    Jason,

    I submit that Fed policy has not been “loose” in that it can’t simply deem credit easy by decree (and hence does not “create” capital).
    It’s like a big city mayor decreeing apartments cheap by mandating rents below the market clearing price. What incentive is there for capital to migrate to new housing units if landlords can’t earn a return on investment that reflects the business risks they are assuming? The result is housing shortages.
    So in the case of the Fed, if interest rates are being artifically depressed, where is my incentive to offer my savings to the market if I cannot earn a return that compensates me for the risk of deferring my consumption? I think this helps explain why only the most credit worthy (governments and multinational corporations) have not had trouble accessing credit in recent years but small- and medium-sized businesses have found it quite difficult to access “easy” credit.

    1. Hi Bob,

      Thank you for your comments. I think we will have to agree to disagree on this one. If central banks cannot create easy money and loose credit conditions then what is the point of central banks engaging in their policies? If you are arguing that they do not influence the cost of money, and hence affect the supply and demand of credit then how did interest rates get so low after the Great Recession.

      Your analogy is also not quite analogous, because central bank policies affect the price of everything in an economy, not just rents in a single city. So there are not too many leakages out of the system, the way there are with the “big city rents” example.

      Last, your arguments seems to rely on a mental model of “supply and demand set market prices.” If true, this analysis relies on the conditions for such a mental model being in place for the conclusions drawn from it to be correct. But that is the very case I am arguing: central banks corrupt the functioning of markets.

      If I am off in this comment, please feel free to use the forum here to demonstrate your case.

      So the case that I am making is that businesses continue to use WACC vs. cost of capital correctly, but that a 2% spread on projects that are approved now are on a much lower absolute level of return. Many projects now wouldn’t even garner the attention of the CFO function at a firm in years past, but now are the sugar plum fairies in the minds of many managers. You can hear this when you read through 8Ks and see the types of projects that now obsess managers (I refer to many of these in my piece, above). A 2% spread when costs of capital are normalized are for game changing projects like new products, new technologies, grand global strategy, key restructuring, and so forth.

      Yours, in service,

      Jason

  6. Ilir Shkurti says:

    Jason: it is a very engaging read. I read it twice and I am struggling to reconcile the final “gutless managers” point with the rest of the write-up. I am assuming you are (rightly) pointing out many “Type 1” errors in projects taken on today as a result of lower interest rates. I interpret this as capital managers growing more risk-tolerant, i.e. requiring lower absolute rates of return due to the relative rate framework. If anything, this should imply “too much gut” and too little selectivity of risk.

    Yet, a quick “empirical” survey of corporate behaviors today suggests companies are still shy to fully invest their “pilling” cash, resulting in the mismatch between revenues and EPS trends you point out. This could be attributed to a continuing focus on controlling cost rather than growing, in my opinion, that stems from a Great Recession-relaated PTS syndrome, indeed fitting the “gutless” characterization.

    I suppose what I am saying is, I miss the transition in the article or may need a couple of further reads.

    Long time reader, first time commenter, and hopeful for some good level 3 results this August,

    ilir

    1. Hello Ilir,

      Excellent news regarding you joining the comments stream – nice to know we have another learned, intelligent contributor out there.

      I think you read my post correctly, but your interpretation and narrative of the facts differs from mine. My interpretation/narrative is that risks in the overall ecosystem have not actually lowered by much, but have been artificially kept low. In this environment, the prudent thing to do would be to continue to demand higher, absolute rates of return as compared with WACC. If firms still demanded 10-15% returns, but could fund at 3.5%, the spreads would be very high. Instead, firms have lowered their hurdle rates, since they are market based. Consequently, they are approving many dozens of projects and capital choices that would never normally pass muster. So I am saying that this is a risk to the system.

      Also, I need to address my ‘gutless’ characterization because several comments have mentioned it. I did not say that corporate finance people were gutless, I said I fear that a generation of corporate managers is being hatched that will be gutless. I was trying to suggest that the future for corporate earnings looks bleak once costs of capital normalize because of the mentality I feel is developing. Right now what is missing is an appreciation for a once-in-a-lifetime opportunity to earn outsized returns on capital projects since funding costs are held artificially low. But instead, corporate finance pros are using relative spreads to evaluate projects. Ouch!

      An analogy may help: The behaviors I witness are similar to the child that has been handed everything by a doting parent and had to work for nothing. When the subsidy of the child is rolled back the child does not know how to survive in the world because he doesn’t know how to take risks, or to think very large about her life, or how to solve life’s big problems.

      I hope this helps to reveal my intent : )

      Yours, in service,

      Jason

  7. Priyamvada Trivedi says:

    Hi Jason,

    It was a great article…the first of its kind that I have read actually.But I have one question, the trend till now always has been to tune investment rates as per market rates – relativity has always existed. If we wipe out relativity, how will the interest costs actually be calculated…

    Thanks,
    Priyamvada

    1. Hello Priyavada,

      Thank you for your compliment and for your question.

      Let me try to clarify…I am not saying to scrap the intellectual framework for executing corporate finance. Instead, I am saying that capital decision makers need to recognize that costs of capital are artificially held low, and that very low return projects are consequently being approved that would never normally be approved in a regular costs of capital environment. This is creating a large risk for the future of capitalism to my mind.

      My suggested framework is for firms to continue to fund themselves with the ridiculously low costs of capital available to them (around 3%) and likely using 100% debt, but to raise their required rates of return back to normalized levels (i.e. 10-12%). This should create an outsized spread and lead to the approval of fewer projects, but they are likely to be “game-changers.” Instead, though, corporate finance pros are adjusting their mindsets to only see the world as containing low return, low risk, non-game changing projects.

      Once interest rates normalize – i.e. central banks pull back on their massive stimulus activities – then firms can maintain their required rates of return, WACCs will increase, and a return to the normal “relative rates” based capital budgeting will return.

      Does this make sense?

      Yours, in service,

      Jason

  8. Moksh says:

    Hey!!

    I can understand why you would suggest to use normalized WACC but then what about cash flows? Shouldn’t they also be protected as if we are in a normalized word? I think Prof. Damodaran had raised this point in his blog and has suggested to use the actual WACC and then also project cash flows actually because the normalized world doesn’t exist. Can you please throw some light on the same?

    1. Hi Moksh,

      Point 1, Normal Environments Do Exist: I think it is entirely fair to think of a “normalized world” existing in financial markets. Let me share with you an example. Take a look at http://www.cfapubs.org and look for a game-changing and amazing article written by the late, great Peter Bernstein and the still vibrant Rob Arnott (http://www.cfapubs.org/doi/pdf/10.2469/faj.v58.n2.2524). The paper was about long-run equity returns relative to debt returns – they went back over one hundred years. The conclusion was that the run up in equity prices from around 1980-2005 was unprecedented in human history and that they were not reflective of reality. Bernstein and Arnott’s point was that prudent portfolio managers should use normalized return expectations when thinking about the future direction of equity markets. So, too, should pension funds think of normalized rates of return on various asset classes.

      Point 2, Independent Estimates of Cost of Capital: Many people do not spend the time to consider the philosophy underlying rates of return and costs of capital. Why do they exist? They exist because there are distortions to equilibrium created by time, space, preferences, risks, and so forth between one person’s surrender of capital to someone else. In other words, what leads to someone else forgoing use of capital right now to someone else? A cost of capital, or required rate of return, clearly. I would argue that there are permanent factors that can be baked into costs of capital, including information asymmetries, different funding time horizons, different perceptions of risk, and so on. The creation of the Internet has permanently lowered the cost of information discovery for everyone, so you would expect that costs of capital would be permanently lower because of the Internet’s existence. That said, there are different interpretations of factual data, and different ways of discounting the future. So there are going to be differences of opinion in costs of capital between providers of capital and users of capital. Here, cost of capital can be negotiated between the two parties to adjust for differences of opinion.

      You might also expect there to be adjustments for all other factors, too. My point is that you could build theoretical costs of capital without using markets, and this would be independent of current market activity. I think there is such a thing, costs of capital independent of market activity. We use market rates, not necessarily because they are correct, but because they are convenient when we build our models. In normal circumstances we can use market rates because they are likely to be relatively unbiased, and reflective of a number of market participants’ beliefs about what capital ought to cost. However, what are prudent capital decision makers to do when there are large scale distortions in a system? Here, an estimate of cost of capital independent of distortions is called for.

      To summarize this point, my belief is that markets are not always efficient and that it is possible for entire markets to be poor price estimators (i.e. bubbles do happen). When these environments exist – and I think that is exactly the environment we are in right now – then it makes sense to create a non-market based estimate of cost of capital.

      Point 3, Don’t Double Count Risk – Discounted cash flow analysis can handle estimates of risk and return in two places:in the estimated cash flows and in the require rate of return. It sounds as if Aswath counsels to handle this in the flow portion of the equation. I am arguing that in the current environment if you are to handle estimates of required rates of return that it is dangerous to use market-based rates. SUPER importantly, when building a discounted cash flow model (same as a capital budgeting model) then it is critical that you do not double count risk. In other words, if you handle the risk in the estimate of cash flows, then do not double count risk in the cost of capital. The reverse is also true. If Aswath counsels handling risk in flows, I am certain that he has good reasons for it. I am counseling that people are likely using the wrong estimate of risks in the required rate of return portion.

      Point 4 – The beautiful thing about investing is that results are not subjectively measured, but objectively. Yet, analysis is subjectively executed, not objectively. Meaning that, we all have our opinions : ) and I am certain that your perspective is also a valuable one.

      Thank you, thank you for your interest in The Enterprising Investor!

      Jason

  9. Ashok says:

    Hello Jason,

    Another thoughtful piece.

    I know this is a US centric issue (low risk free rate) yet important to the rest of the world. In my part of the world (India) corporate managers largely use qualitative factors over quantitative factors while evaluating decisions.

    So that is a right brain approach, right 🙂

    For example, managers ask – how we do capture markets 5 years hence if we invest now. Should we invest in project A so that smaller projects B,C,D can be easily won easily, if we win A. Should we partner with company X for bidding for certain project A even though our share in the profits may be lower. Should we lever up 3x for a business that breaks even in 10 years. Should I invest in project A that gives me good advertising and visibility to the world while my rest of the business thrives.

    One issue is I have never comprehended whether capital budgeting framework traditionally considers these aspects or not. The knock-on effects, the competitive threat factor, the rent-seeking that companies, rightly or wrongly, aspire to gain.

    I am hazarding a guess that similar issues and manager traits might be present in the US as well.

    I am also deeply influenced by Buffet’s statement that cost of capital is not a precise number for all, but the opportunity cost of the next best thing to each one. Many companies in India imbibe that thought quite naturally.

    Thank you again for an interesting piece.

    Regards
    Ashok

    1. Hello Ashok!

      Thank you for sharing the Indian story with the audience. Super interesting information that you have shared.

      Yours, in service,

      Jason

  10. AlbertoAW says:

    Thanks for the article Jason, it’s brilliant. It reminds me to the ideas brought by austrian economists (Menger, Böhm-Bawerk, Mises, Hayek, etc). My question is: these economists state that we suffer business cycles due to the manipulation of interest rates by Central Banks, not allowing economic agents to make proper capital budgeting decisions by receiving the wrong signal (level of interest rates not backed by savings). But at the end, Central Banks manipulate short term “risk-free” rate, what you call the root. Above that root there are several spreads (maturity, creit risk, expected inflation, etc.) which are set by markets. Wouldn’t be the final result of adding the base or root with all spreads the same as in a pure free market where interest rates would be set freely? Maybe in a pure free market we would start from a higher root but then we would add lower spreads. Thank you in advance!

    1. Hello Alberto,

      First, thank you for the high praise for the piece. I felt compelled to write this piece because I think the life blood of capitalism is innovation, and since 2009 most of the innovation being expressed at companies is in the form of financial engineering (debt refi, stock buybacks), and not of the ‘how do we grow our top-line’ kind,

      Second, I am sympathetic to the Austrians’ fascination with free-markets. But, in practice and in my opinion, it is a Utopian ideal (and the polar opposite of the Utopian-ideal of pure socialism) that will never be achieved. This is a much broader conversation than I am prepared to fully express in the comments section, too. But I will say that my initial assumption about markets is that they are not truly free, not truly a perfect pricing mechanism, and they are frequently manipulated by various authorities. Some of the authorities are central banks and bureaucratic entities, but still others are market enthusiasts themselves (see: LIBOR, for example). Given this assumption, my goal as a financial professional is to recognize when markets are far from a normal range of typical distortions, and to then use adjustments. I think this is an elegant solution to an imperfect world.

      Again, thanks for making me smile today!

      Jason

  11. Savio Cardozo says:

    Hello Jason
    Thanks to you and your readers for an engaging and informative discussion on this subject.
    One question if I may.
    In calculating WACC, when you use market value weights, do the equity and preferred weights go up sufficiently to counteract the effect of low debt weights, or should normalized rates still be used when using market value weights, or do normalized rates only apply to book value weights?
    Much appreciate and a pleasant evening
    Savio

    1. Hi Savio,

      The orthodox answer to your question is that WACC is determined by a mix of capital sources that is determined by the board of directors of firms in conjunction with the financing function of businesses. When I was an analyst I would talk with management to ask them about their anticipated mix of funding sources over the next 1-3-5 years to be able to better estimate WACC. In this case, I would use market values because when companies access capital markets they need to pay market rates for their capital.

      Note: in my article I believe it is a huge advantage to businesses to be able to fund at market rates right now. The problem is when they set their expected return assumption on a spread over WACC basis. To my thinking the expected rates of return have to be much higher than the current artificially low levels. Put another way, the problem is not WACC, the problem is expected rates of return.

      Enjoy the weekend…hope it is sunny and warm up North!

      Jason

  12. RichardK says:

    Wonderful article!

    I’ve also been concerned about the distortions in the market of the essentially free money provided by a 0 prime rate.

    I have one idea I’d like to get your opinion on..

    One thing I think that is happening here is a perception that deep troubles will follow an increase in the prime rate based on the raw amount of debt held by the US Government. The more raw debt we have, the larger macro effect an increase in rates will bring, since rolling over those instruments to buy new ones will increase the service load for all outstanding debt. I wonder if we’ve crossed a ‘point of no return’ regarding this.. and this is yet another incentive to keep prime at 0. If this is the case, then only tough love will do at the government level (and honestly, I don’t think that will happen..).

    Again.. wonderful article.. glad I stumbled onto this site! 🙂

    1. Hello Richard,

      Thank you for your kind words.

      Yes, the issue you raise is a real issue and for me it boils down to two things: time horizon orientation, and the force of will of central banks. In the short-term there is likely to be pain as rates are increased and as debt burdens are rolled over at higher rates. But what happens long-term if the price of money is distorted? So for what time horizon do be hold central banks accountable? I would argue that they are responsible for all time horizons, and that the long-term risks are growing and larger than the short-term risks. So I desire that they let rates float more freely before permanent changes in capital investment decision makers’ behaviors has taken place. With regard to the second issue, the central banks need will power to stand down the inevitable complaining and whining of the disaffected.

      Yours, in service,

      Jason

  13. J. Greg Turner, CFA says:

    Very deep, yet very simple to comprehend, and probably spot on. If only active analysts / managers were still a significant force in setting stock prices to get managements’ attention…

    1. Hello Greg,

      Thank you for your comments, I especially like your point about the proportion of prices being set by active analysts/managers.

      Yours, in service,

      Jason

  14. Shan says:

    Good article. I agree that listed companies are perhaps relying too much on buybacks and are becoming gutless and listless. However, there is another angle – the unlisted startups which are truly going places where few listed companies dare to go. The rise of unicorns is well documented and is at a historic high. I believe there are multiple reasons for this but ZIRP is perhaps a key reason as well. If you take a holistic view then I would say the gutsy attitude has simply moved from listed to unlisted players. Whether this is good or bad or how it affects your portfolio is a different matter but I’d not go so far to say that capitalism itself is in danger of destruction.

    1. Hello Shan,

      Thank you for your comment and for taking the time to share your thoughts with readers. Start ups may be a mitigating factor. However, I would argue that it may mean that many of the unicorns would not have been funded in past eras because the business models were not compelling enough, or did not generate revenues soon enough. I think the poor state of the unicorns’ balance sheets bears this point out. For the sake of capitalism I hope that you are right.

      Yours, in service,

      Jason

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