Massive investor popularity can produce some pretty strange circumstances in the U.S. stock market. Mark Twain said, “History doesn’t repeat itself, but it rhymes!” Today’s strange occurrence has been called a “zero cost of capital” and it rhymes with what happened in 1999-2000. This is a phrase coined by NYU Business Professor Scott Galloway in his effort to explain the moat surrounding today’s tech darlings. What is a “zero cost of capital” and why does it exist today? How long might it last and does it guide us as long-duration investors on where to place our capital?
What Is A Zero Cost Of Capital?
Normally, publicly traded businesses are subject to a significant price to raise capital to fund their growth. If you borrow money, the interest rate is the cost of capital, combined with being obliged to pay it back at maturity. If you sell common stock, you dilute the share of future profits for existing shareholders. A simplistic way to think about the cost is the inversion of the company price-to-earnings ratio (P/E). As a back of the envelope exercise, a company trading at a P/E of 10 would spend 10 percent to issue new shares.
All of this has been brought to light by a terrific piece on The Wall Street Journal website called, “Bull Market in Tech-Company Convertible Debt Rages On.” Writer Maureen Farrell tells us that today we have the most publicly traded convertible bonds in existence paying little or zero interest since the year 2000. Here is how she explains this rhyme:
Publicly traded technology companies have been issuing bonds that convert into equity at a pace unseen since the height of the dot-com bubble as demand for tech stocks surges.
So far this year, 24 U.S. technology companies have issued $11 billion of convertible bonds, the highest volume in a comparable period since 2000 and 29 percent above the already-elevated level of 2017, according to Dealogic.
For those of you who need refamiliarization with the instrument, companies raise capital either via issuing common/preferred stock, selling bonds or by selling hybrid bonds called converts. Investors collect interest on these bonds and at some point in the future they have the right to convert the bonds into common shares. Her article goes on to say:
Three—Nutanix Inc., RingCentral Inc. and Etsy Inc.—have issued convertible bonds this year that pay no interest. Since the dot-com crash, such deals have been relatively rare. Only 13 other companies had issued convertible bonds without coupons since then.
When you borrow money by selling bonds, which are paying no interest and are only convertible into equity at much higher prices, you effectively provide those companies capital which costs nothing! Galloway argues that extremely high P/E ratios on stocks like Amazon (AMZN), Tesla (TSLA) and Netflix (NFLX) implies a nearly zero rate for them. A 200 P/E multiple inverts to an interest rate of 0.5 percent.