The Quest for Yield

Interest rates are at all-time lows. Developed economies seem trapped in a slow-growth malaise. Every major asset class seems priced to perfection. So where should investors turn? 

Our investment philosophy at Verdad centers on the importance of the yield at the time of purchase. We focus on free cash flow yield, which is comparable to a bond’s current yield. This yield is knowable ex ante and forecast-free.

In figure 1, we have ranked a range of investable asset classes by their current yield.

Figure 1: Asset Classes Ranked by Current Yield

Source: CapitalIQ, Verdad, Pitchbook, Stanford Search Fund Study

As you can see, yields are low across the board. Broad equity market indices are trading at a 2–3% free cash flow yield. If you add expected global GDP growth of 2–3%, you come to an expected return for these asset classes of 4–6% — net of changes in valuation multiple. Most major bond indices’ returns rank lower and do not have the benefit of potential growth. Small/risky equity sectors (e.g., US small cap, energy, metals and mining, and emerging markets) are yielding nothing at all or have negative yields. The only asset classes with >5% yields are high-yield bonds, Japanese equities, private equity, leveraged small value stocks (Verdad’s strategy), and search funds.

How predictive is this yield-based analysis?  We strongly believe — and our research supports — that free cash flow yield is predictive of future equity returns in the cross-section of stocks. Recent academic research suggests that yield, or “carry” as some refer to it, is more broadly predictive of future asset class returns and is useful to compare across asset classes.

That said, the future is too chaotic for this to be more than a rough and imperfect guide. Of the many things that are important to the eventual return on investment — growth, exit price, etc. — yield is, however, the only component that is knowable ex ante. If you multiply the importance by knowability, purchase yield is the most important consideration in making investments, by a mile. Here’s how we think about this balance:

Figure 2: Importance vs. Knowability

Purchase yields are both known and important; thus we believe they are the best available tools to use to predict expected returns. Even armed with these tools, we see the future through a glass, darkly and know only in part.