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Motilal Oswal Asset Allocation Passive Fund of Fund – Aggressive (G) - 11.3846Motilal Oswal Asset Allocation Passive Fund of Fund – Aggressive-Dir (G) - 11.4181Motilal Oswal Asset Allocation Passive Fund of Fund – Conservative (G) - 10.9654Motilal Oswal Asset Allocation Passive Fund of Fund – Conservative-Dir(G) - 11.0015Motilal Oswal Dynamic Fund (Div-A) - 14.1399Motilal Oswal Dynamic Fund (Div-Q) - 12.664Motilal Oswal Dynamic Fund (G) - 15.6026Motilal Oswal Dynamic Fund-Dir (Div-A) - 14.3632Motilal Oswal Dynamic Fund-Dir (Div-Q) - 12.8792Motilal Oswal Dynamic Fund-Dir (G) - 16.5268Motilal Oswal Equity Hybrid Fund - Direct (G) - 16.4362Motilal Oswal Equity Hybrid Fund - Regular (G) - 15.6555Motilal Oswal Flexi Cap Fund(D) - 27.2528Motilal Oswal Flexi Cap Fund(G) - 36.2551Motilal Oswal Flexi Cap Fund-Dir(D) - 27.3405Motilal Oswal Flexi Cap Fund-Dir(G) - 38.8868Motilal Oswal Focused 25 Fund - Direct (D) - 22.5111Motilal Oswal Focused 25 Fund - Direct (G) - 38.4537Motilal Oswal Focused 25 Fund (D) - 20.1781Motilal Oswal Focused 25 Fund (G) - 34.3801Motilal Oswal Large and Midcap Fund - Dir (D) - 17.3261Motilal Oswal Large and Midcap Fund - Dir (G) - 17.3408Motilal Oswal Large and Midcap Fund (D) - 16.7609Motilal Oswal Large and Midcap Fund (G) - 16.761Motilal Oswal Liquid Fund - Direct (Div-D) RI - 10.0077Motilal Oswal Liquid Fund - Direct (Div-F) RI - 10.0043Motilal Oswal Liquid Fund - Direct (Div-M) - 10.03Motilal Oswal Liquid Fund - Direct (Div-Q) - 10.0034Motilal Oswal Liquid Fund - Direct (Div-W) RI - 10.0058Motilal Oswal Liquid Fund - Direct (G) - 11.2006Motilal Oswal Liquid Fund - Regular (Div-D) RI - 10.0055Motilal Oswal Liquid Fund - Regular (Div-F) RI - 10.0042Motilal Oswal Liquid Fund - Regular (Div-M) - 10.03Motilal Oswal Liquid Fund - Regular (Div-Q) - 10.0034Motilal Oswal Liquid Fund - Regular (Div-W) RI - 10.013Motilal Oswal Liquid Fund - Regular (G) - 11.1541Motilal Oswal Long Term Equity Fund (D) - 21.5046Motilal Oswal Long Term Equity Fund (G) - 27.3747Motilal Oswal Long Term Equity Fund -Dir (D) - 25.6699Motilal Oswal Long Term Equity Fund -Dir (G) - 29.9503Motilal Oswal Midcap 30 Fund (D) - 25.6227Motilal Oswal Midcap 30 Fund (G) - 41.9429Motilal Oswal Midcap 30 Fund-Dir (D) - 26.5417Motilal Oswal Midcap 30 Fund-Dir (G) - 46.083Motilal Oswal Multi Asset Fund - Direct (G) - 10.944Motilal Oswal Multi Asset Fund (G) - 10.7567Motilal Oswal Nasdaq 100 FOF - Direct (G) - 23.6638Motilal Oswal Nasdaq 100 FOF - Regular (G) - 23.398Motilal Oswal Nifty 50 Index Fund - Direct (G) - 14.8351Motilal Oswal Nifty 50 Index Fund (G) - 14.726Motilal Oswal Nifty 500 Fund - Direct (G) - 17.1524Motilal Oswal Nifty 500 Fund (G) - 16.925Motilal Oswal Nifty Bank Index Fund - Direct (G) - 13.701Motilal Oswal Nifty Bank Index Fund (G) - 13.5202Motilal Oswal Nifty Midcap 150 Index Fund (G) - 19.7725Motilal Oswal Nifty Midcap 150 Index Fund-Dir (G) - 20.0505Motilal Oswal Nifty Next 50 Index Fund - Dir (G) - 15.0847Motilal Oswal Nifty Next 50 Index Fund (G) - 14.9091Motilal Oswal Nifty Smallcap 250 Index Fund (G) - 20.4288Motilal Oswal Nifty Smallcap 250 Index Fund-Dir(G) - 20.7098Motilal Oswal S&P 500 Index Fund - Direct (G) - 14.865Motilal Oswal S&P 500 Index Fund (G) - 14.7245Motilal Oswal Ultra Short Term Fund - Dir (Div-D) - 10.0029Motilal Oswal Ultra Short Term Fund - Dir (Div-F) - 10.0263Motilal Oswal Ultra Short Term Fund - Dir (Div-M) - 10.0099Motilal Oswal Ultra Short Term Fund - Dir (Div-Q) - 10.1541Motilal Oswal Ultra Short Term Fund - Dir (Div-W) - 10.014Motilal Oswal Ultra Short Term Fund - Dir (G) - 14.173Motilal Oswal Ultra Short Term Fund (Div-D) - 9.9475Motilal Oswal Ultra Short Term Fund (Div-F) - 9.9582Motilal Oswal Ultra Short Term Fund (Div-M) - 9.948Motilal Oswal Ultra Short Term Fund (Div-Q) - 10.0925Motilal Oswal Ultra Short Term Fund (Div-W) - 9.951Motilal Oswal Ultra Short Term Fund (G) - 13.7006

HOW INTEREST RATES MAKE NARRATIVES = VISIONARY, CASH FLOWS = DINOSAURS

Blog Blog Details
  • April 06, 2021
  • Susmit Patodia|
  • Fund Manager

The first lesson weare taught in investing is to focus on the value of a company (which is largelya function of its cash flows) and not the price.

But what if price itself could createvalue! How? If the price is so high that the company canuse it to create significant moats, it can possibly create value. The bestexamples of this are probably the leading tech companies in the US, where they continuouslyuse their stock as currency to acquire smaller companies that could bepotential future challengers.

But what causes prices to go muchbeyond the value of a company? Thereare a multitude of factors like Flows, Low Float, Star CEO, Narratives or recentlyeven Reddit. In this note, lets focus onone factor which are interest rates and how they impact valuation?

Cost of Equityis a function of Risk Premium and Risk Free Rates.

Risk Premium is theextra return that we would want from any investment that promises but does notguarantee returns. In India, apart from sovereign guarantee and INR 5 Lakhs inevery fixed deposit, everything else has a risk premium attached to it. Equitieshave the highest risk premium as the cash flows accruing to equity holders isafter all interest payments, government dues are paid. Equity risk premium overthe long term does not change materially and has seen to be in the range of4-5%.

The second variableinto the Cost of Equity is the risk free rate. A good reference point is the 10Year government security of the country. The change in this over the long termhas been significant and this has impacted the overall Cost of Equity. The UShas seen long term yields go down from 12% in 1980 to 4% in 2002 and now 1.5%.In India, yields have dropped from 14% in the mid 90s to 6% now

To understand theimpact of the fall in risk free rate and subsequently overall cost of equity, we take up a very simple valuation exercise

We have two companiesA and B.

A generates cashflows every year and grows this at 15% every year. At the end of 10 years, weassume a simple terminal value to get the value of the stock.

On the other hand, Bdoes not generate any cash flow but is busy creating a unique business with apromise of a very large terminal value. For arguments sake, we assume theterminal value to be same as company A.

Assuminga 8% Cost of Equity and a 4% Terminal Growth, the difference in valuation of Aand B is A being higher by ~30% but if the Cost of Equity drops to 5%, thedifference shrinks to 7%!





This math is the key to understanding why companies that are cash guzzlers now, but have the promise of a bright future are getting priced at levels similar to or maybe even more than that of companies which are already established and delivering cash flows. In a low interest rate regime, higher growth (expectation) not only gets handsomely rewarded but delayed cash flows get a lower penalty as well.
There is an interesting pro-cyclicality that plays out with non-cash flow generating companies in a low interest rate environment. If a growing company does not generate enough cash flows to fund its growth, it would have to borrow, which is much easier to do in a low-rate environment. Conversely, not only does valuation get impacted as rates go up, the path of growth starts looking more uphill than before. When things turn (which is when interest rates go up) for such companies, it has an effect of a snowball down a steep hill.
If one believes that interest rates have bottomed out, then why are valuations still going up? I am reminded of what Warren Buffet said – What the wise do in the beginning, fools do in the end. Advise caution
The intriguing aspect about talking of value that will be created 10 years down the line is that it is more to do with imagination rather than reality. The victorious claim visionary status while the fallen are termed dinosaurs. There are many alternate histories that could have played out but like in most uncertain decision making situations, the deterministic results decide the correctness of probabilistic decision making. 
I should humbly submit that this is a simplification of the much touted current advancement led by technology that is underway (probably comparable to the industrial revolution and/or the invention of the wheel) and I may not have the “vision” to look into the future. But it is important to not get carried away when valuing businesses. Until the fundamental reason which is that value of company is the sum of all the cash flows that it would generate changes it will be unwise to ignore cash flows for eternity. 



Disclaimer:
This article has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this article are as on date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. The recipient should exercise due caution and/ or seek professional advice before making any decision or entering into any financial obligation based on information, statement or opinion which is expressed herein. 
Investment in securities is subject to market and other risks, and there is no assurance or guarantee that the objectives of any of the strategies of the Portfolio Management Services will be achieved. Please read Disclosure document carefully.

This article was originally published Forbes India on 6th April, 2021
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