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The reasoning used in this circular is identical to that set out in its two predecessors. But unlike them it uses sceptical rather than optimistic assumptions. Its analysis by no means replaces the systematic and thorough scrutiny of an asset’s financial statements. Significantly, however, it provides grounds to believe that reasoned scepticism can produce better long-run investment results than informal optimism. It also suggests that the trade-off between an investment’s risk and return is the opposite of that which is virtually always supposed: the lower an asset’s ’riskiness’ (i.e., the likelihood that its purchase will cause a substantial and permanent loss of capital), in other words, the greater its potential return (i.e., the expected value of its stream of future earnings). This circular therefore derives from first principles several policies which will continue to guide Leithner & Company’s operations during the 2000-2001 financial year. Their crux: if unwarranted optimism motivates speculation, then reasoned scepticism will underlie our investment operations.
A Comparable Scenario
To maintain consistency with the examples in the ‘Irrational Exuberance’ circulars, consider again their starting points and the choice of buying either a hypothetical five-year Commonwealth Government bond with a yield of 6.1% (the yield of these bonds on 1 June) or one share of a hypothetical company called X Ltd. Assume that the market price of both securities is $1.00. Assume as well that X Ltd is ‘sound’ in the sense that it has an established (5-10 year) track record with respect to three criteria. The first is effectiveness, i.e., the generation of a real and growing stream of earnings. The second is efficiency, i.e., the use of modest amounts of capital to generate these earnings. And the third is managerial rationality: those earnings which management has retained within the company rather than paid to its owners as dividends have not been squandered or destroyed; rather, they have been used to generate higher earnings in subsequent years.
As in the previous circulars, assume again that whether you choose the bond or the stock you are a long term investor and will hold the asset for at least five years. If you buy the bond, then by mid-2005 you will earn $0.31 (i.e., a stream of $0.061 per year for five years); and during its five-year life it will return to you $1.31 (i.e., the $1.00 principal plus the five interest payments). Given the bond’s ‘risk-free’ nature, it makes sense to buy the stock only if there are strong grounds to believe that during the next five years it will return to you significantly more than $1.31.
How much more? That depends upon the ‘risk premium’ which (either consciously or not) you require in order to buy the share rather than the bond. Recall that a Commonwealth bond is in two senses (but not in others) a risk-free asset: its interest payments are fixed and virtually perfectly predictable over time. In both senses common stocks are riskier: first, their earnings are variable rather than fixed (indeed, they may not eventuate at all); secondly, their earnings are much less predictable than the bond’s earnings. Accordingly, given the prospect of an equivalent stream of earnings from a Commonwealth bond and a particular share, by how much must the share’s earnings yield exceed the bond’s earnings yield (or, equivalently, how much cheaper must the share be relative to the bond) before you are prepared to buy the share? The greater the disparity the greater the risk premium which, consciously or not, you require from the share.
Some Purposefully Dour Assumptions
Despite the conservative and stringent assumptions which we are making about it, there are reasonable grounds to infer not just that X Ltd will be able to return at least $1.31 in 2005 – but also that X Ltd’s return will surpass the risk premium which virtually any investor might impute to it. These assumptions and their consequences are summarised in Table 1.
Assumption/Decision Rule #1
Our first assumption is that in 2001 X Ltd’s earnings per share (E.P.S.) will be $0.133. We assume, in other words, that any purchase at today’s price of $1.00 will turn out to be equivalent to 7.5 times X Ltd’s E.P.S. in 2001. This assumption is conservative because value investors strive to purchase equity at lower price multiples (and hence higher earnings yields). If, for example, we resolve to purchase X Ltd at no more than five times its current (2000) earnings and are actually able to do so, then our purchase price of $1.00 per share implies that earnings per share for 2000 are $0.20. Our first decision rule is therefore very robust in the sense that it allows for the possibility that X Ltd’s earnings will decrease by as much as 33% during the next twelve months.
Table 1:
A Thumbnail Evaluation of a Typical ‘Value’ Investment
Year |
E.P.S. |
Yield on $1.00 Investment |
Annual Dividend (50% Payout) |
Shareholders’ Equity |
| 2001 |
$0.133 |
13.3% |
$0.067 |
$1.067 |
| 2002 |
$0.140 |
14.0% |
$0.070 |
$1.137 |
| 2003 |
$0.147 |
14.7% |
$0.074 |
$1.211 |
| 2004 |
$0.154 |
15.4% |
$0.077 |
$1.288 |
| 2005 |
$0.162 |
16.2% |
$0.081 |
$1.369 |
| Totals |
$0.736 |
11.7% compound p.a. |
$0.369 |
$1.369 |
Assumption/Decision Rule #2
Table 1 makes a second stringent assumption: the earnings per share of X Ltd, notwithstanding their growth in the past, will increase during the next five years at a virtually-stagnant annual compound rate of no more than 5%. Our decision rule, in other words, is to adopt a consciously pessimistic view about X Ltd’s future operations. This is sensibly cautious. On the one hand, during the past five years companies with track records such as that of X Ltd have been able to increase their E.P.S. at approximately 1.5 to 2 times this rate (and in some instances more). Clearly, however, a track record of sound operating results hardly guarantees that these results will continue into the future. This point is particularly apposite to periods of strong economic growth such as that experienced in Australia since the mid-1990s. Our second assumption, then, is also robust in the sense that it incorporates the possibility that X’s sound track record will subsequently deteriorate into mediocrity.
Assumption/Decision Rule #3
Thirdly, Table 1 assumes that X Ltd’s current per-share shareholders’ equity is $1.00 (value investors strive to pay no more – and preferably less – than book value) and that in the next five years it will return half its earnings to its owners as a dividend and retain the other half. The corresponding decision rules are that we buy companies at no more than book value (which is not the same as intrinsic value) and with a solid record and prospects of paying dividends.
Some Immediate Implications and a More Explicit Conception of Risk
These purposefully unadventurous assumptions, if they actually come to fruition, have several startling sets of implications. They also illuminate our conception of the risk which inheres in any investment operation.
The first implication is that in 2001 the earnings yield – - E.P.S. divided by our purchase price of $1.00 – on our investment in X Ltd (13.3%) will be more than twice that of the bond’s yield (6.1%). Moreover, this yield increases modestly thereafter such that in 2005 it is almost three times the bond’s yield. Not only are each of X Ltd’s five coupons significantly greater than the bond’s corresponding coupon: the extent of this disparity increases over time. Accordingly, at the end of the fifth year cumulative earnings of $0.74 – two-and-one-half times more than the ‘risk-free’ bond’s cumulative earnings of $0.31 – accrue to the owner of the X Ltd share. Indeed, in the sense that cumulative earnings of $1.08 are generated by 2007, this investment will ‘pay for itself’ within seven years. In this first sense, our purchase of X Ltd clearly possesses what Benjamin Graham called a ‘margin of safety.’
Second, if all unfolds according to these lacklustre plans then during the next five years X Ltd will pay us a total of $0.37 in dividends. In order to match the bond’s total return, in five years we must therefore be able to sell our X Ltd share for at least $0.94 (i.e., $1.31 minus $0.37). In this sense, too, the implications of our decision rules are robust and provide a reasonable margin of safety. If X’s operations deteriorate more than our already-pessimistic assumptions allow (or if for some other reason the market price of its shares stagnates) and we must sell the X Ltd share for $0.06 less than we paid for it, our stream of dividends – if they transpire according to our assumptions – still assures us a compound return equal to that of the bond (i.e., 5.5% per year). If, however, its operating results do meet our conservative expectations, and if we are willing to assume that market participants will in five years’ time attach the same price multiple (1.0) to its shareholders’ equity that they do today, then we would expect that X Ltd’s shares will sell for $1.37. Under these conditions our compound return (including dividends) increases to 11.7% per annum. And if X Ltd’s operating results during the next five years are comparable to those observed during the last five years then they will exceed our sober expectations, its shares’ market quotation (again assuming that market participants will attach the same multiple to its shareholders’ equity) will be higher and our compound return higher still.
As a general rule, then, we accept the risk which inheres in an investment only when its positives greatly outweigh its negatives, i.e., the ‘upside’ seems to be more likely than the ‘downside.’ Given its past operations and current market price, X Ltd - unlike most ‘blue chips’ and virtually all ‘tech market darlings’ – seems to possess this characteristic.
...continued in Part II
 
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