CIO Insights 2Q2025

In our quarterly CIO letter exactly 20 years ago, we opined that interest rates—and by extension the discount rate to value assets such as equities—in hard currency countries were too low given future economic risks known at the time. Today, the 10-year US Treasury bond yield as the world’s leading long-term benchmark is indeed slightly higher than it was in the middle of 2005. What we didn’t know at the time was that monetary authorities around the globe were forced to engineer much lower rates over the course of those two decades in response to the massive dislocations caused by crises such as the US subprime collapse (2007/8), the European peripheral debt crisis (2011/12) and the Covid-19 pandemic (2020/21). But even today after the rebound in headline yields over the last three years, we continue to believe that the market’s implied discount rates hover at too optimistic levels.

 The first reason has to do with the risk-free interest component in pricing equities. Risk-free rates are affected by expected inflation and real rates. The latter have recovered from their historic lows (in a healthy economy they should average in a range of 1 and 2%). However, one should bear in mind the current resurrection of tariffs as a foreign policy tool. It suggests to some that the “global dollar”—the use of the US dollar as the world’s reserve currency of choice—is no longer unquestioned. This may eventually lead to upward pressure on US real yields in case foreign demand for US treasury debt wanes. Now in terms of inflation, the market assumes that its re-emergence over the last four years has largely been tamed. We wouldn’t be so sure. First, the need for massive spending in areas such as renewable energy, health care, defense and infrastructure will prevent governments from being able to rein in their ever-rising indebtedness. Of course, the most convenient way for sovereign borrowers to manage their debt burden is to inflate it away. On top of that, ongoing supply chain rearrangements on the back of tariffs and reshoring, as well as labor shortages and rising commodity costs, are also not helping inflation to come down.

The second component of the expected return for equity owners is the price of residual risk above and beyond the “risk-free” bond yield. Here we must distinguish between systematic and idiosyncratic (diversifiable) equity risk. We believe that systematic risk has become underrated. There may the so-called “financial repression” effect at play here. That is, fixed-income instruments such as government bonds have lost some of their appeal as a natural diversifier due to the low yields available for much of the last one-and-a-half decades. Thus, many savers who don’t explicitly adhere to a balanced portfolio policy have gradually opted to increase their exposure to equities. Most of that money in turn has been plowed into the index-heavyweights, pushing their valuations ever higher. Theory and prudence would predict that after periods of higher-than-normal returns, investors will trim their expectations going forward. However, that’s not what most people are inclined to do. Instead, they are emboldened to extrapolate the recent time-series trend and thus run the danger of overestimating future returns.

Fortunately, our deep value approach has two built-in mechanisms to sidestep this behavioral trap. First, experience shows that the typical equity holding in our investment program exhibits a mean-reversion path. Consequently, our portfolio management process calls for selling shares that have risen because they presumably got closer to their intrinsic value. Conversely, we buy more of those that have fallen to reduce our average entry price. This rebalancing discipline should restore the expected long-range return profile for the aggregate portfolio. Second, expected returns of our stock selections tend to be challenged to begin with because of a poor earnings picture or other inhibiting factors. Hence, the market assigns them a relatively high hurdle rate in terms of the cost of equity capital to account for the perceived elevated idiosyncratic risk. In this respect, our approach is ahead of the curve because its valuation process already bakes in higher rates.

In hindsight, investing in the stock market for much of the four decades between 1982 and 2022 felt like “a walk in the park”—it was enough to simply buy an index fund and “forget about it.” A fair share of the unparalleled equity performance during that period should be credited to falling discount rates. This feat won’t be repeated anytime soon, but we believe that our portfolio management and valuation processes are properly attuned to handle the ramifications.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG