Equity duration and the current sell-off - all about timing and discounting cash flows

 

There has been some compelling research work that focuses on the timing of equity cash flows, or equity duration, to explain some of the recent movement in cross-sectional stock behavior. The basic investment idea is that the concept of bond duration can be applied to equity cash flow timing. If cash flows are backloaded, an equity will have a longer duration from stocks that have cash flows more certain and clearly defined in the near-term. The implications are clear from the classic formula for duration which accounts for the timing of cash flows. 

The equity that has longer duration will be more sensitive to changes in the discount rate and changes in the distant cash flows. Hence, if there are rising rates, these equities will see a greater negative impact. Of course, these stocks have benefitted more from low rates in the post GFC period and during the most recent decline in rates.  (See "Equity Duration" for a recent example. The equity duration idea has been kicking arounds for more than two decades but has recently been given new focus.) Nevertheless, there is compelling evidence that low duration stocks should do better than long duration stocks.

Determining the timing of cash flows for equities is not an easy problem. Equity duration can be measured through several unique but justifiable models: cash flows, growth forecasts, and bond-beta approaches. It certainly is more difficult than any calculation of a bond's duration where the cash flows are well-defined. The idea of an equity duration can be contrasted with other risk factors, but the true value comes from the primal nature of focusing on cash flows. 

Equity duration can account for the wild swings in price of growth stocks that will be affected by expectations of long-term cash flows. Long duration will be more sensitive to cash flows volatility and changes in the business cycle and will be more susceptible to stock mispricing.

The low duration stocks have the same characteristics as value, high profitability, low investment, and low risk stocks; however, the link between duration and value is not one for one. Both have value for measuring differences in stock risk.

Equity duration is intuitive and can provide another way to look at factor risks that are helpful with explaining some of the differences cross-sectional stock behavior.