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The analysis in Part I begs an obvious question: given a stock of capital and the necessity to invest, what constitutes a reasonable rate of return on one’s investment? To answer this question, consider the actual behaviour of borrowers and lenders. There is some compromise amount at which some people (creditors) are willing to forego the use of money today in exchange for the right to receive a specified greater amount in the future, and at which other people (i.e., debtors) are prepared to enjoy the use of the money today in exchange for the obligation to provide a specified greater amount in the future.
At this compromise amount, i.e., the natural rate of interest, some people will willingly lend and others will voluntarily borrow. The rate to which borrowers commit themselves is the future opportunity cost of undertaking current consumption which is otherwise beyond their means; and this same rate to which lenders commit themselves is their reward for delaying the consumption they could otherwise afford today. In reaching this compromise, individuals undertake subjective calculations. Each lender, for example, decides what he is prepared to sacrifice now in order to obtain the expectation of a particular stream (or lump sum, etc.) of future benefits. Equivalently, each lender compares the satisfaction that he must forego today to the satisfaction derived from the additional purchasing power he expects to receive at a specified point, interval, etc., in the future.
Lenders who discount more heavily (i.e., are less willing to forego current satisfaction in anticipation of future benefits) or are less certain that the benefits will eventuate require more substantial compensation in order to induce them to part with their money. The higher an individual’s required compensation the higher his implied time preference. (Time preferences differ from one person to another, and a given person will evince different time preferences at different stages of his life. Bearing these points in mind, as well as the non-representative samples and non-laboratory conditions that exist in a postgraduate classroom, the informal experiments that I undertook at The University of Queensland in 1999-2003 suggest that the natural rate of interest in Australia is presently ca. 12-15%).
Bonds and Stocks, Lending and Owning
We can extend this line of reasoning to the analysis of the two fundamental types of securities: bonds and stocks. (The attentive reader will see that “real estate” does not comprise a distinct type of security: like any other asset, it is either used by its owner or borrowed/lent). A bond is a legally-binding commitment to pay a fixed amount(s) of money at a fixed date(s). In exchange for an agreed amount of money, an entity such as an individual, business or government sells to another entity (i.e., bondholders) a promise whose characteristics have been specified and agreed before the transaction. Adelaide Bank Ltd, for example, has issued bonds (ASX Code: ADBHA) which in essence promise two things. First, the bank will pay bondholders $2.10 quarterly until 15 June 2004; second, on that date the bank will repay to bondholders the bonds’ face value of $100.00 (i.e., the amount that the bondholders originally lent to the bank). A bond might subsequently be sold by its initial purchaser to a third party, and by that party to a fourth party, etc. The price at which the bond changes hands may vary, but its terms and conditions – the amount(s) that the business has undertaken to pay the bondholder, the dates of payment and redemption, etc. – remain fixed. To own a bond is therefore to own a debt. The owner of a bond issued by a business, in other words, possesses a contract with that business – a contract whose terms must be honoured whether or not the business’ revenues exceed its expenses.
If, for example, the business does not have sufficient cash to meet interest payments or redeem its bonds, then it must sell sufficient assets to do so. And if it does not possess enough assets fully to discharge its obligations to bondholders and other creditors, then they can force the business into liquidation and extract as much as possible of the amounts owed to them. In this respect a bondholder resembles an employee. Each, in effect, is a creditor; accordingly, the business is legally committed to pay them contractually agreed amounts at specified points in time. In sharp contrast, the owners of a business – whether a single individual or millions of stockholders – are legally entitled to nothing except what might remain after a business has fully discharged its obligations to employees, bondholders and other creditors. Adelaide Bank Ltd must first pay its employees, bondholders and other creditors what they are owed. Next in the queue are the owners of its preference shares (ASX Code: ADBPA), who receive fixed dividends according to the procedures set out in this security’s prospectus.
What remains after these obligations have been discharged is the “profit” that, either as retained earnings or dividends, belongs to the owners of its common stock (ASX Code: ADB). During the past decade Australian banks have developed a reputation for solid and reliable profitability. Clearly, however there can be no guarantee that a given business will trade profitably in the future. To own common stock is thus to own a share of a business; and to own a business is to possess a claim to whatever net earnings it might generate. Further, and bearing in mind that most new businesses fail within a few years, what remains after employees and creditors have been paid what they are owed can be negative as well as positive. The owners of a business, in other words, may not only fail to make a profit: they may also lose part or all of what they invested in the business.
Lending and Owning Imply Different Amounts of Risk
To own a particular stock (equity) or bond (debt) is to possess a specified bundle of property rights. To own property, as Value Investing, Risk and Risk Management derived from first principles, is to incur risk. That series of circulars defined risk as the probability (fully knowable only in retrospect) that the ownership of a given bundle of property rights does not produce its expected or desired results (“good things”) and instead generates undesirable, unforeseen and unintended consequences (“bad things”). It defined investment risk as the likelihood that an investment decision taken today, i.e., the decision to retain or purchase a particular bundle of property rights, causes a particular “bad thing” – relative or absolute financial loss – to occur at some point in the future.
Given that they specify different types of rights over property, the ownership of bonds and stocks often imparts different amounts of investment risk. The bondholder’s principal risk is that the company that owes money to him will default (i.e., dishonour its promise to pay interest on its bonds). Under these circumstances the bondholder receives no return on his capital. For the owner of a business’ debt, the worst-case scenario (i.e., ultimate risk) is that the company is forced into bankruptcy and is able to pay neither principal nor interest. If so, then the bondholder receives no return of his capital. The equity-owner’s principal risk is that an unexpectedly small – or negative – residual (i.e., “profit”) remains after his business has fully discharged its obligations to its various creditors. If so, then the owner earns no return on his equity. From the point of view of an owner, the worst-case scenario is that the business fails and no assets remain after employees and creditors have been paid.
....continued in Part III
 
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