the Basics

I’ve had several requests recently to talk about investing basics. I thought I could refer to past posts, but I don’t appear to have put down in one or two places how I think the markets work and what possible investments are available to you and me. Hence, this series of posts.

stocks, bonds, cash …and you and your family

have a financial plan for your household

Most Americans invest for two reasons: to send their children to college and to fund their own retirements. A friend who’s a teacher in the Netherlands points out that outside the US neither may be the burning issue it is here, since a lot of that is taken care of either by the national government or by your job. Still, I’d imagine we all think of investing as a way to have a better future lifestyle.

Individual circumstances for each of us will determine a lot about how we approach investing. Part of this is when you’ll need access to the money we’re investing. Part is risk preferences (how willing or able we are to suffer a loss). Part is the security of your job and other assets/ liabilities you may have (like house/mortgage).

The outlines of a financial plan, however simple, will probably identify the kinds of risk you might consider taking and what, in contrast, might be out of bounds.

three classes of liquid investment

The three are: cash, bonds and stocks (equities).

–cash. a bank account, a money market fund, a very short-term Treasury bill or CD. You lend your money in return for its safe storage + at least partial protection from the reduction in purchasing power that inflation causes. Often, you can direct your cash to a third party. But what really distinguishes cash from other liquid investments is that it is returnable to the owner on demand.

–bonds. lots of different maturities and levels of creditworthiness, from government bonds to corporate to low credit-grade “junk” or tax-advantaged municipal. In each case, though, there’s a bond agreement that specifies what interest payments will be paid to the holder, and when, plus the length of time after which the lender must return the principal. One key difference between In today’s world, the benchmark bond is the 10-year US Treasury note. That’s in part because there are a lot of them and some issues (called “on the run”) figure in bond derivatives, in part because the 10-year is the long bond standard in the rest of the world. (Note: so-called “perpetual” bonds do exist, meaning the loan never terminates and you (some exceptions) never get your principal back. But there are few of them, so let’s ignore them.)

Bond analysis centers around the value in to day’s money of its stream of future payments, the degree of certainty that the borrower will make those payments, the alternatives available and one’s ability to buy and sell.

Long-term studies I’ve seen years ago suggest that a 10-year government bond should yield inflation +3 percentage points per year. Over the past decade, however, the 10-year US Treasury has yielded inflation +~0.5% annually.

–stocks. In contrast to bonds, which are loans to a (hopefully) trustworthy party which entitle the lender to interest payments and return of principal at a specified time, stocks give the holder an ownership interest in an ongoing enterprise.

Because of this, analysis of stocks, i.e., the question of what an ownership interest is worth, is not as straightforward as with bonds. Two schools have emerged in the US as the main approaches to dealing with this question. This doesn’t mean these are the only approaches–in fact, my experience is that markets abroad can operate on very different principles. But I find them good explanations for the way Wall Street behaves.

The older of the two schools is value investing. It originated during the Great Depression of the 1930s, a time when many companies were trading below the value of their net working capital and sometimes below their net cash. “Net” here means left over after paying all company liabilities. “Working capital” means cash + inventories + short-term trade receivables (normally paid within, say, 90 days).

Benjamin Graham, the father of the movement, said, in effect, these companies are like $100 bills lying in the street. Why bother with anything else?

As the world recovered after WWII, and all these bargains disappeared, the value school evolved into a search for asset-rich companies whose profits, and stock prices, are temporarily depressed for business cycle reasons or because of poor management (on the uniquely US idea that the responsible individuals could and would be replaced). Another line of attack is to locate conglomerates whose parts, if separated, would sell for (much) more than the group all clumped together.

The second school is growth investing. It’s goal is to find companies where the current stock price implies a lower growth rate in revenues and profits, and/or a shorter period of superior growth, than the firms will end up achieving.

The same studies that suggest the “right” annual return over long periods of time on government bonds is inflation +3 percentage points opine that the similar figure for equities should be a return of inflation + 6 percentage points. I’m not sure either figure is really that relevant in the present market situation, but at least it’s a point of reference to start a discussion from. And I think at least the conclusion that the return on stocks should be higher than that on government bonds–to compensate for the greater risk of the former–is spot-on.

For what it’s worth, I started out as a value investor and I worked for about half my career in value-oriented organizations. My view changed in the mid-1980s, when I started to manage money in Pacific Basin markets. I was immediately attracted to mid-cap industrials in Hong Kong that were trading at single digit price-earnings multiples, despite having enormous growth potential stemming from their roots in the mainland. After a few years of this, I realized I’d shifted from focusing on the multiples to the potential for explosive growth–I’d become a growth stock investor!

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