Sunday, January 13, 2013

Discount rate dissonance

There has to be a huge cognitive dissonance occurring in investor's minds right now around the issue of hurdle rate. Everyone who ever took a managerial finance course knows that a reasonable discount rate for any Capex project is 10%. Sure, nominal interest rates are zero and real interest rates are negative, but who can really believe this when it comes to capital budgeting? Hence, the concentration on nominal spreads, or as Rosie puts it, "cash flow is king." But everyone knows the dangers of investing in stocks based on dividend yield only. Are investors really aware of the probability of capital loss in real estate investment? What happens when mortgage rates go up by a few hundred basis points?

It is common to talk about uncertainty as the cause of investment insufficiency in a liquidity trap, but the fact remains that capital losses are built into a zero interest rate environment. Last one out is a rotten egg. But it may be a while. Last time we had zero interest rates it lasted well over a decade. We might well have them until the end of this decade, or close to it.

This is really a golden age for privately held firms. They don't have to answer to that green eyed monster, the stock market. For the kleptocratic managements of publicly held corporations, the current environment simply fosters a get rich quick mentality to a greater extent than ever before. Why not take on some low-cost debt and buy back even more stock? Yet another reason that the stock market has become a suckers' game.

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