Why Does Zero Cost Of Capital Exist Today?
The most obvious reason for the low cost of capital is the historically low interest rates of the last 10 years. Bonds and stocks both took their cues from the alternative U.S. treasury interest rates. Even with the low interest rates established by the government, up and coming companies pay junk bond interest rates to borrow in the public market. Using Tesla as a recent example, their common stock trades at an infinite P/E ratio because they are losing money. Their junk bonds are rated CCC+, were issued to yield 5.3 percent, and trade underwater at 87 cents on the dollar.
Smead Capital Management believes the next reason is that we are in a classic financial euphoria episode as described in John Kenneth Galbraith’s, A Short History of Financial Euphoria. As described in his book, investors are suffering from what is called “recency bias.” Once a trend lasts long enough, investors extrapolate the trend way out into the future based on momentum. Here is how Galbraith explains it:
Let the following be one of the unfailing rules by which the individual investor and, needless to say, the pension and other institutional-fund manager are guided; there is the possibility, even the likelihood, of self-approving and extravagantly error-prone behavior on the part of those closely associated with money.
Galbraith explains that those who pursue the trend are grouped as two kinds of participants. One group is made up of supposedly smart people who buy in and are ready to leave with one foot out the door. The second group is made up of less experienced investors who feel pioneering and empowered by being alive when common men and women anticipate getting rich.
Remember that Warren Buffett says, “What the wise man does at the beginning, the fool does at the end.” Galbraith says it this way:
A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is time for caution.
How Long Might A Zero Cost Of Capital Exist?
Judging by Maureen’s article, not much longer:
The surge in convertible debt worries some investors who see a bubble developing at a time when there are signs the multiyear bull market in stocks has run its course. But that has yet to damp demand.