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 you’re investing. Part is risk preferences (how willing or able, financially or psychologically, 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. there are lots of different maturities and levels of creditworthiness, from government bonds to corporate to low credit-grade “junk” or tax-advantaged state or local 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. 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 US government is regarded as a very trustworthy borrower, unlikely to default, and partly because the 10-year term 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 today’s money of its stream of future payments, the degree of certainty that the borrower will make those payments and what happens if they don’t, 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.

value and growth: two different approaches

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).

Teaching at Columbia, Benjamin Graham, the father of the value movement back then, said, in effect, there companies are like $100 bills lying in the street. Why bother with anything else?

This low level of stock prices relative to the underlying companies’ assets is highly unusual for the US. The only other period I can think of that was even close to this was the bottom of the market in 1974. The world was in recession (I was in school in Germany for most of this and had no idea what was going on, so my knowledge comes from books and from talking to Wall Streeters working at that time). Oil prices were spiking. The UK–a major economy–was bankrupt and had to be bailed out by the International Monetary Fund. The “Nifty Fifty” stock market bubble had popped and those stocks, like Xerox or National Lead, which had been trading at astronomical prices, were spiraling downward. Investors were in a panic and rationalized selling companies for less than the net cash on the balance sheet (when it was obviously (in hindsight) loony to do so) by saying that money in the hands of “those fools,” i.e. management, must be worth less than 100 cents on the dollar.

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 can and will be replaced). Another line of attack has been 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 point of view began to change 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 low multiples to the potential for explosive growth not yet recognized by stock market investors. I’d become a growth stock investor.

stocks, bonds, cash–my view of what they are and how they relate

Cash is the simplest of the three. Held in a money market account, it will accrue interest at a rate that’s most likely below the inflation rate. So in today’s world, and in the US, it will generate a small nominal gain but deliver a small real (i.e., adjusted for inflation) loss. I view it as kind of a placeholder that’s in a portfolio because you figure one idea has run its course but you haven’t located a replacement yet. Some people will raise cash because they think stock prices are at a temporary high point and are due for a considerable fall. This is a legitimate position to take. My experience, however, is that most of us, even seasoned professional investors, are pretty terrible at market timing. Typically, portfolio managers either mistime their sale or, if they get this right, they fail to reinvest before the market has rebounded substantially from its lows.

Bonds are a type of loan. To some degree, bonds and commercial bank loans are substitutes for each other for non-government bond issuers (governments typically sell more or less directly to investors). In fact, high yield (i.e., “junk”) bonds came into being in the US in the 1980s as a lower-cost alternative to bank loans for companies with less-than-pristine credit histories, much in the way money market funds emerged a decade earlier as a competitor to bank savings accounts.

A bond is usually issued with a fixed date specified, say, ten years in the future, when the principal must be repaid, plus a schedule for periodic interest payments to be made to the holder over the life of the bond. A 10-year Treasury, for example, might be issued on April 5, 2021. The buyer would pay the government $1000 in return for the promise of a fixed payment of $17/year in interest plus the return of the $1000 on 4/5/31. A bank loan, in contrast, may have an interest rate that varies; more important, the bank credit committee has the power to demand early repayment, on short notice, if it senses the borrower’s creditworthiness is deteriorating.

As is the case with almost everything in financial markets, there are myriad variations on my simple model. Zero-coupon bonds pay no interest, for example; some bonds offer the lender collateral, some don’t; some bonds are callable, some aren’t… But fixed interest rate/fixed term is the general idea.

Because the burning issue with bonds is whether the holder will be repaid on time, bond analysis is credit analysis. It’s concerned more with how bad things can get before repayment is threatened, rather than how good things might get, which is the heart of equity analysis.

Again, generally speaking, two main factors can alter the value of a bond–a change in the issuer’s creditworthiness or a change in interest rates.

For us as equity investors, the far more important consideration is interest rates. An (admittedly unrealistic) illustration:

–The government sells a 10-year Treasury with a coupon rate of 2% (Why coupon rate? Many years ago, bonds had little coupons attached to the edges of the bond certificate, each one of which gave you the right to an interest payment. Holders clipped them and cashed in at the local bank). The deal: $20 a year + $1000 back ten years hence.

–A week later interest rates are at 5% (this is the unrealistic part). The deal on a brand-new 10-year is your $1000 payment gets you $50 a year + return of principal in ten years.

Is the 2% bond still worth $1000? No. The holder of the earlier bond gets $30 a year less than the new bond that is selling for $1000, so it can’t be worth the same.

–same situation, only with two 30-year Treasuries with different coupons.

Is the 2% coupon 30-year worth more or less than the 2% 10-year? The answer must be that the 30-year is worth less, since the holder gets the now-insufficient coupon for 3x as long.

Two points to take from this:

–when interest rates are rising, the price of fixed-coupon bonds goes down; and the price of longer-dated bonds goes down more than shorter-dated equivalents.

–when interest rates are falling, on the other hand, the opposite happens. Both bonds go up in price, with the longer-dated going up more.

Another issue: the 10-year Treasury peaked at about 15.5% in the late summer of 1981 and has been on a downtrend for the past 40 years. It reached a low of 0.55% during the worst of the pandemic last year before rebounding to the current 1.7% or so. Arguably, managing a government bond portfolio over that time has been like shooting fish in a barrel, since the long bond is so sensitive to changes in interest rates ( rates down = bond price up, and vice versa). There have only been brief periods where rates have reversed themselves–and even then only to be followed by further declines.

We’ve now bounced off the 0% line, propelled by the end of the economically toxic Trump administration. Arguably, as the pandemic ends, the economy heals and large fiscal stimulus is applied, we’re in a situation where the interest rate trend is flat to up–something very few professionals now working have ever experienced before. How will bond pros proceed? …unclear.

Stocks, in contrast, have a dual character. Like bonds, they are bits of data traded in financial markets. But they are also tied to the physical world in a way bonds are not, because they are also ownership interests in ongoing enterprises. The fundamental question a stock holder must answer is not “How confident am I that I’ll be paid back?” but rather “Is the company poorly understood, and therefore undervalued at the current price, by Wall Street.?”.

Traditionally, professional equity managers have attacked this second question from two different directions:

–are the assets the company possesses undervalued by the stock market? if so, why and how can this change? This is the “value” approach

–can the company grow earnings faster and/or for longer than the market now expects. This is the “growth” approach.

Academic finance, a quintessentially ivory tower discipline, takes a different view, also two-pronged:

–the older, stemming from the Great Depression of the 1930s, argues that stocks are a funny, extra-risky kind of bond. If so, today’s fair value can be seen as being the present value of all future cash flows–just as the price of a fixed income instrument can be calculated as the present value of future interest payments + principal return. This is called the (Gordon) dividend discount model. While in principle it sounds good, experience shows that professional securities analysts have difficulty coming up with accurate forecasts for company earnings even one year ahead.

the Nifty Fifty bubble of the 1970s

The DDM did end up having disastrous real world consequences during the early 1970s. This happened before my time in the stock market, so I’ve just read about it and spoken with older colleagues who lived through it. The market came to believe that there was a group of companies, dubbed the Nifty Fifty, whose businesses were so powerful that they would continue to grow strongly for decades. If you accept this as the case, the present value of future earnings ends up being enormous, enough to justify buying the stock in question without much regard to the current price. These were called “one decision” stocks, just buy them and wait for the gains to roll in.

Some of the fifty, like Coke, or Walmart, or Disney, survive to this day. But others, like Simplicity Pattern, National Lead, Kresge, Polaroid or Digital Equipment have all fallen by the wayside. What I think separates one group from the other is that the former were willing and able to reinvent themselves as either times changed or they saturated their original markets.

–the more recent approach, from the 1970s, argues that the stock market is so efficient at pricing that the market itself, or a broad index like the S&P 500 that acts as a proxy for the market, is the best possible portfolio. Active management will just muck things up. The intellectual underpinnings are seated in the European Enlightenment notion that the world we live in has been created by a benevolent God, who has actualized the best of all possibilities. This theory is presented in more secular terms as the markets being the result of the “invisible hand” guiding them to the best possible outcome. This Panglossian view is known as the efficient markets hypothesis.

how interest rates influence stock prices