Until a few years ago, I used to generalize investment risk in terms of asset classes and sectors. Like many investors, I mistakenly focused on product labels instead of looking at the basics of how the different investments actually function. By that I mean, how investors realize investment returns. That led me to focus more on the nature of cash flows to the investor because paper profits eventually have to be converted into cash for the investor to realize a return.
Most people understand the basics of how bonds work. And because bonds have contractual cash flows to which we can compare other streams of cash flows, we can relate all investments to the various types of bonds. For example, residential real estate is so easily understood because very stable monthly rent “coupons” are paid in cash and most residential real estate has a relatively stable face amount (property value). Essentially, it performs much like a plain vanilla bond, except the coupons and face amounts vary gradually over time and it does not mature. Alternatively, it’s easy to see why commodities and other non-cash producing assets can be so volatile when we view them as zero coupon bonds with highly variable face amounts and no maturity.
The right way to view stocks is as junior bonds with variable coupons, variable face amounts and no maturity dates. Judging a company’s ability to produce future free cash flows for the owners’ benefit is really not much different than a creditor judging a company’s ability to generate cash flows to make timely principal and interest payments. Like bonds, stocks can have collateral in the form of shareholder equity that could possibly be recovered through liquidation.
When comparing relative attractiveness of different investments, required returns make much more sense when relating all investments to bonds. Stock investors should require a higher rate of return than bond investors because, 1) Stocks are junior to bonds in the capital structure; 2) Coupons of stocks (free cash flows) are variable in their amounts and timing; 3) Face amounts of stocks (business values) are variable; and 4) Businesses do not “mature,” so stocks should be viewed as perpetual bonds and, as such, are likely to be extremely sensitive to changes in interest rates and spreads on risk assets.
Additionally, companies don’t normally pay out all of their “coupon” free cash flows to shareholders via dividends. This may require an additional risk premium because stock investors have to rely on management to intelligently allocate retained cash flows in order to preserve or increase value. This can be done through, 1) Share repurchases; 2) Acquisitions; 3) Debt reduction; 4) Business growth; 5) Mergers; 6) Resource conversion; 7) Investments; or, 8) Buyouts. All of these require skilled, shareholder-oriented management or a change in control. Either way, investors are eventually dependent upon a higher price in order to sell and realize any increase in value.
Viewing stocks in this manner should help investors better understand risk-reward relationships among different investments. And this should ultimately help improve investment performance through more intelligent selection of the available risk-reward opportunities.
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Disclosure: No Positions