Although bumps will occur in the short-term, “in Australia we will experience a similar medium-term trend” (6 June). More specifically, “most enterprises in Australia can reduce their operating costs by 20 to 30 percent over the next three years by embracing the new technology systems” (5 June). Accordingly, “analysts are optimistic about established [Australian] companies because of the cost reductions that are coming via the new technologies. Some of these economies are being achieved via the establishment of large business-to-business market places” (27-28 May). Not surprisingly, a survey by Macquarie Bank finds that, notwithstanding the recent volatility of market prices, almost two-thirds of margin lending clients intend to buy more Australian shares during the next twelve months. The first theme is thus that many market participants are optimistic, and if you stick with selected ‘blue-chips’ (such as the “100 Hottest Stocks” selected by “Australia’s Business Experts” in The Australian on 5 June) you’ll be OK.
If the first theme is giddy optimism, the second, to put it bluntly, is blind delusion. An article in The Weekend Australian (27-28 May), entitled “Tech Check Reveals Value,” distilled this theme’s essence. In an impressive display of babble, it stated that
- “the force of the new technology paradigm that has driven growth during the past three months should ensure the latest correction will be temporary” and that
- “the underlying information technology growth story and its impact on the new economy remain as pervasive today as they did a year ago.”
It therefore concluded not only that
- “sound technology stocks [will] remain in favour because of their underlying growth potential, coupled with fundamental market position and management strength,” but also that
- “the dotcom and technology sector will probably provide better capital returns to the discerning investor than the equivalent small cap old technology stock” (italics added).
A Dissenting Argument
This two-part circular, in sharp contrast, demonstrates that very generous (to the companies concerned) assumptions, simple-yet-rigorous reasoning and information readily available to the general public yield the conclusion that the purchase at current prices of the shares of many of Australia’s largest companies and seemingly safest securities, i.e., ‘blue chips’, does not provide investors with what Benjamin Graham called a “margin of safety.” Nor do ‘leading technology’ companies – whether or not their operating cash flows are positive – provide comfort. This conclusion does not imply that the prices of these securities will fall: for all I know – and I don’t – they might remain as they are, or rise and remain at inflated levels. Rather, it cautions that the purchase of these securities at these prices is a speculation rather than an investment.
Starting Points
In order to reason towards this conclusion we require two assumptions and five corollaries:Assumption #1: to invest is to forego jam today in the expectation that one’s investment capital will generate helpings of jam for tomorrow, the day after and the future. In Warren Buffett’s words, “Investing is laying out money now to get more money back in the future – more money in real terms, after taking inflation into account.”
- Corollary A: if this is to occur, then an investment must not only produce a stream of earnings (“coupons,” as I will call them); its growth must outpace the effects of inflation and other taxes.
- Corollary B: at least two motivations underlie the decision to invest: These include the necessity that the real value of one’s capital be maintained and the desire that that capital generate a secure and growing stream of earnings.
Assumption #2: the stream of earnings which an investment generates need not be passed immediately or directly to its owner. Stocks’ dividends and bonds’ interest payments are returned to their owners today. In contrast, companies’ retained earnings are returned indirectly, over time and – if the company does not first erode or destroy them – in the form of an increase in the asset’s market price.
- Corollary C: the expected value of an income stream, which depends upon its size and the expectation that it continues into the future, is a key criterion by which one can evaluate an asset’s investment potential. A Commonwealth bond, for instance, is in two senses (but not in others) a “risk-free” asset: the interest payments which its owner receives are both fixed and virtually perfectly predictable over time. Real estate is a riskier asset because rental income is both more variable and less predictable over time; and common stocks and corporate bonds are riskier still because their earnings and ability to make interest payments, respectively, are even more variable and less predictable.
- Corollary D: given the risks of the erosion or destruction of investment capital and the coupons it produces, a direct and immediate stream of earnings is preferable to an indirect and delayed one.
- Corollary E: the investor seeks to purchase assets which provide (i) streams of future earnings (ii) of a given expected value (iii) at a price (i.e., rate of return) which compensates adequately for the risk which inheres in the investment.
Bonds’ and Shares’ Coupons
In order to apply these starting points, consider a corporate bond. Assume that its initial seller (a corporation) pledges to pay its initial buyer (an investor) $60 per year for 5 years, that the corporation sells it to the investor for $1,000 and that at the end of the 5 years the corporation pledges both to pay the last instalment of interest and to repay the $1,000. The bond thus generates a $60 stream of annual earnings (coupon) and has an initial annual yield of 6% (i.e., $60/$1,000). No matter how many times or at what price the bond subsequently changes hands, the $60 annual coupon remains fixed. Accordingly, the higher (lower) the price at which the bond is sold, the lower (higher) its annual yield. The price the initial and any subsequent investor will be willing to pay for the bond depends upon three risks: the expected rate of inflation over the bond’s remaining life; the yield on “risk-free” Commonwealth bonds maturing at the same time; and the “risk premium” (i.e., investors’ perception of the corporation’s ability to pay the $60 annual coupon and repay the $1,000 on time). The greater the perception of each of these three risks, the lower the bond’s price and the higher its yield.
The “coupon” of a company’s shares is merely its earnings per share (E.P.S.); and its earnings yield is E.P.S. divided by its shares’ purchase price. As an example, consider a company which earns ten cents per share, some of whose shares were purchased by an investor for $2.00 each and whose earnings are assumed to grow at a rate of 25% per year over the next five years. At the end of the first year, its owner receives a coupon of ten cents per share (either cash in hand, i.e., a dividend; or as earnings retained and re-invested in the company; or as some combination of the two). This represents an earnings yield of 5.0% on the initial investment of $2.00 per share (i.e., $0.10/$2.00 = 0.05). At the end of the second year, the coupon grows to 12.5 cents per share (i.e., a 25% increase over the previous year), which represents a yield of 6.3% on the investment of $2.00. If the coupon really does grow at the assumed rate for each of the five years then the earnings yield increases year by year such that, at the end of the fifth year, it reaches 12.2%.
Clearly then, if a company is able to increase its earnings then the yield on one’s initial investment also increases over time. This is a fundamental attribute which distinguishes ownership of a company’s equity (shares) from ownership of its debt (bonds). And it is this compounding which makes the ownership of excellent businesses – if they or a part thereof can be bought at a sensible price – so rewarding, since the price of equity will tend over time to rise roughly in tandem with the growth of its earnings.
Evaluating an Asset Using a Commonwealth Bond as a Benchmark
We can apply this logic set to determine whether a “risky” asset, such as a particular company’s bonds or common stock, offers a better or worse potential return than a “risk free” asset such as a Commonwealth bond. Generally speaking, shares are more attractive only when their earnings yields and streams are significantly greater than bonds’. Conversely, bonds are more attractive when their yields are equal to or greater than stocks’. More generally, and all else equal, the higher a share’s (bond’s) earnings yield relative to that of a “risk free” Commonwealth bond, the greater its attractiveness as an investment.
These rules-of-thumb should be regarded as just that: they do not (and the examples below do not purport to) replace a thorough and systematic analysis of a company’s financial statements. They are, however, a good way to make explicit some of the key assumptions of a financial transaction which would otherwise remain obscure. Carol Loomis, writing in Fortune on 7 February 2000, used similar ideas to illustrate the heroic (for AOL shareholders) assumptions which underlie the merger of America Online and Time-Warner Communications.
Example #1: A (Fallen) Tech Market Darling
Surely the shares of Solution 6, a tarnished tech market darling whose shares have fallen from more than $18.00 late last year to approximately $3.00 on 1 June, are now available at a bargain price?
To decide this question, assume you have the choice of buying either one share of Solution 6 at $3.00 or a hypothetical five-year $3.00 Commonwealth bond with a yield of 6.1% (the yield of five-year Commonwealth bonds on 1 June). Assume as well that whichever you choose you are a “long term” investor and will retain your choice for five years. If so, then by mid-2005, you will have earned $0.90 (i.e., a stream of $0.18 per year for five years) in coupons from the bond, and during its life the bond will return a total of $3.90 (i.e., the $3.00 principle plus the $0.90 in interest payments). If the Solution 6 share is to be a better investment than the Commonwealth bond, then clearly it must return to you at least $3.90 in five years’ time. At first glance, given that SOH has sold for as much as $18.00 during the past twelve months, this will surely be a very easy hurdle to jump.
But when we look at hard figures rather than soft PR and adopt the perspective of an investor (the owner of a share in a business) rather than a speculator (the owner of an interest in a wager) this hurdle becomes much more formidable. Table 1 makes several generous assumptions about the future operations of Solution 6. The first is that it will earn $0.104 per share during the financial year which ends 30 June 2001. This assumption is very generous because Solution 6 has never earned more – and has usually earned considerably less – than $0.104 per share. Indeed, since it listed on the ASX almost ten years ago SOH has earned an average of exactly $0.00 per share. It has never earned more than $0.104 per share, has lost money as often as it has earned it and has lost as much as $0.348 per share. Our first generous assumption is therefore that SOH’s earnings will improve dramatically and to an unprecedented level during the next twelve months.
The table also makes a second generous assumption: the earnings per share of Solution 6 will increase each year over the next five years at a compound rate of 15%. This assumption is extremely generous because SOH has never been able to increase its earnings per share from one year to the next. We, however, are assuming not only that it will do so five years in succession – but also that it will do so at a more rapid rate than most other large (i.e., ASX 100) Australian companies have managed to do during the past five years.
These generous assumptions have several startling implications. Most notably, if $0.182 per share is earned in 2005 and if all goes to plan during the preceding years then at the end of the fifth year cumulative earnings of only $0.70 – considerably less than the ‘risk-free’ bond’s cumulative earnings of $0.85 – will accrue to the Solution 6 shareholder. Further, even in the fifth year SOH’s projected earnings yield fails to exceed that available today from a “risk free” Commonwealth bond (6.0% versus the bond’s 6.1%). Finally, given that its E.P.S. is assumed to be eighteen cents in 2005, the SOH share must sell at no less than 21 times ($3.90/$0.18) its projected earnings in 2005 in order simply to approach the bond’s risk-free return.
SOH’s operations, then, must improve by an unprecedented extent and unfold exactly according to these very generous assumptions for the full five-year period in order in the fifth year to provide a return which only approaches that guaranteed today from a five-year Commonwealth bond. What are the chances that these generous and optimistic assumptions will transpire? Should we accept them? An exuberant answer to the first question and an affirmative one to the second provides the rationale for the purchase of SOH at today’s drastically-reduced prices. If the SOH share’s return is to exceed that of the Commonwealth bond then one of two things must occur: first, our already-generous assumptions must turn out to be conservative; second, Solution 6’s share price must increase much more quickly than its earnings. SOH’s operations to date justify neither of these expectations. Clearly, then, even at its present ‘low’ price Solution 6 remains a risk-fraught speculation rather than a sensible investment.
... continued in Part II
