The Concept Of Equity Carry

by: Ben Emons

Summary

"Carry" in fixed income is well known. It is a return of holding a bond to maturity by earning yield versus holding cash.

"Carry" in stocks is a less known concept. "Stock carry" can be loosely defined as the difference between “free cash flow or dividend yield” and the company's cost of debt.

Carry is derived from the yield curve and although that is not applicable to stocks, equity investors may take note of carry as a way to find value in stocks.

A fixed income investor can earn a relatively stable return from "carry" and "roll down." Carry is defined as the difference between a yield of a bond and interest on overnight cash. Roll down return comes from the slope of the yield curve. Say an investor purchased a bond with a 5-year maturity that has a coupon/yield of 2 percent and a price at par (100). If a 4-year maturity bond from the same issuer (or comparable issuer) is yielding 1.8 percent, then a roll down return of 20 basis points (0.002 percent, the difference between the yield of a 5-year and 4-year maturity) can be earned over the period of one year, provided the slope of the yield curve does not materially change. The total return would be calculated as 4.8 years of duration of the bond multiplied by 20 basis points of roll down plus the yield of 2 percent. The total return would be approximately 3 percent all else being equal. It is not a guaranteed return but it is capital gains that can be collected over time if an investor is patient.

Carry and roll return is a very different concept for stocks however. It is difficult to imagine a "stocks yield curve." Stocks do not have a yield to maturity. The only company specific yield curve would be corporate debt issued at different maturities. For example, Apple and Verizon have issued corporate bonds with a maturity as short as 1-year and as long as 30-years. But let's think for a moment conceptually about the "equity yield curve." Say a common stock trades at a different price/earnings multiple than the preferred stock, convertible preferred, class A shares or B shares or its internationally issued stock. There would be different earning yields on each of these stocks of the same company. That would explain price differences between stocks of a company on different exchanges. This is because the earnings yield (reciprocal of PE ratio) of a company's foreign subsidiary could be higher than at it's home office. So in conceptual terms, earnings yields on different type of stocks (preferred, common, A etc.) may represent a "term structure" of earnings yields.

Another comparison is by using dividend yields of companies that operate in the same sector. There could be a "curve" of dividend, free cash flow and earning yields of different companies in the same sector. It's not the traditional term structure of yields like in fixed income. Rather, it is a "credit curve" that expresses the different risks between stocks on domestic and foreign stock exchanges. The risks would be liquidity, currency and cost capital that can be lower (or higher) overseas than at home due to funding or taxation differences. However, unlike in bonds, an investor would not "hold on" to a stock to try to earn a roll down return. The way a stock investor would earn "carry" would be through the average free cash flow yield or dividend yield after subtracting the weighted average cost of its short-term debt.

A "equity carry concept" by looking at a yield curve as how such is practiced in fixed income is most likely applicable to multinational companies that have overseas operations and stocks listed on foreign exchanges, or companies that have a stable history of paying dividend. About 250 companies listed in the S&P 500 pay dividend. Their market cap weighted average dividend yield is 3.25 percent and market cap weighted cost of debt is 1.96 percent. In simplistic terms, the S&P 500 Index has a "positive carry" of 1.29 percent.

Although that seems attractive, a better measure is carry per unit of duration risk. In fixed income, a way to express carry per unit of risk is to look at the difference between a bond's spot and forward price divided by duration. For dividend stocks, a forward price can be calculated based on cost of financing (margin), a "risk free rate" and dividend yield. An investor could for example compare a company's stock carry per unit of risk to corporate debt carry per unit of risk. By using stock spot and forward stock prices of the 250 companies in the S&P 500, the market cap weighted average stock carry per unit of equity risk is around 40 basis points (0.4 percent). The market cap weighted average carry of corporate debt per unit of duration risk of those companies is around 65 to 80 basis points (0.6 to 0.8 percent, expressed as a broad average). This may broadly indicate corporate bonds are currently more attractively priced than stocks in terms of carry per unit of risk.

Not all fixed income relative value methods fully apply to stocks. However, for stable dividend and multinational stocks, fixed income relative value analysis could be practical. Companies for example like AT&T, Phillip Morris, General Motors and Pfizer. These companies pay since 2008 a stable dividend (35-55 cents/quarter) with dividend yields of 3.5 to 4.5 percent. Their year to date equity returns are +7 to 10 percent, and they have relatively low PE multiples (8 to 18). The "stock carry" is higher or close to the carry of their corporate debt (estimate 20 to 25 basis points). For stock pickers, much more fundamental factors would go into the analysis of these four companies. Adding fixed income analysis to the mix can provide additional insights in stock valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.