Leithner & Co Pty Ltd - Risk&Return: Restating Some Fundamentals for Value Investors

RISK AND RETURN:
RESTATING SOME FUNDAMENTALS
FOR VALUE INVESTORS

Part III

15 July 2003

...continued from Part II

Like a man travelling in foggy weather, those at some distance before him on the road he sees wrapped up in the fog, as well as those behind him, and also the people in the fields on each side; but near him all appears clear, though in truth he is as much in the fog as any of them.

Benjamin Franklin
The Autobiography of Benjamin Franklin (1757)

It follows from Part II that risk inheres in the ownership of both debt and equity. Indeed, in extremis both the creditors and the owners of a business may lose their entire investment. But if necessary equity must be liquidated in order to pay debt, and therefore owners stand last in the queue at liquidation. Further, the less sound and stable a business is perceived to be, the less the likelihood that it will be able to issue bonds. Accordingly, for these and other reasons the owners of equity typically shoulder greater risk than the owners of debt.

Example #1

To see this, imagine (as does Thomas Sowell in Basic Economics: A Citizen’s Guide to the Economy, Basic Books, 2000, ISBN: 046508138) that someone seeks to raise money in order to launch a business. Let us say that (1) the chances are 50-50 that this business will go bust within five years and (2) if it survives, then within five years its equity (i.e., its net assets) will increase ten-fold. (Perhaps this business will drill for gold or speculate in futures contracts – i.e., drill on the floor of the stock exchange). Assume that the company’s promoter invites you to invest $100,000 in this venture. You are confident that you understand the risks it entails and wish to proceed. Should you buy $100,000 worth of this company’s stock or an equivalent amount of its bonds?

Let us say that the promoter offers to sell you a bond. In exchange for $100,000 today, the venture promises to pay you $2,500 every three months and in five years to repay the $100,000. If you purchase the bond, the probability that you will eventually recoup your initial investment is only 0.50. And if the business prospers – indeed, no matter how much money it makes – you are entitled to no more than the fixed quarterly payments and the return of your principal. Given the nature of this venture and the terms of the bond, there appears to be much “downside” and little “upside.” Relative to its possible reward, in other words, the bond’s risk seems to be prohibitive. There is a 50% chance of losing your $100,000 and a 50% chance of receiving $50,000 of interest payments plus the return of your principal. Depending upon additional assumptions (such as the timing of any liquidation, the amount realised during liquidation, etc.) the bond’s expected annualised return is therefore roughly 5%.

The purchase of this company’s stock, on the other hand, might make sense. It is true that in the event of failure the equity-holder’s loss is likely to exceed the bond-holder’s loss, and that the creditor’s loss cannot exceed the owner’s loss. (Assuming that the company initially has $100,000 of assets and a bond liability of $100,000, in the event of bankruptcy the stock will likely be worthless but the bond might have some value, even if it is just pennies on the dollar, based upon the sale of whatever the business owns at the time of liquidation). On the other hand, if the business succeeds and its net assets multiply ten-fold, then the stock has somewhat more “downside” but considerably more “upside” than the bond. Indeed, given these assumptions the stock’s expected annualised return is approximately 29%. More generally, for any quarterly bond payment less than $49,859 (and an implied interest rate of 58.4%) the stock is more attractive than the bond; and if the venture’s advantages are perceived to outweigh its disadvantages, and if its margin of safety exceeds that offered by any other opportunity at one’s disposal, then the purchase of this stock makes sense.

Following Sowell’s example, assume further that you are a venture capitalist with $1m to invest and that you have the opportunity to buy $100,000 worth of stock in ten enterprises whose investment characteristics are identical to this one. You can therefore expect that after five years the net assets of five of the ten will increase ten-fold and that the others will fail. Subtracting $0.5m (lost from the five failures) from $5m (obtained from the five that succeed) you will earn $4.5m from your initial outlay of $1m. Even if only one of the ten succeeds, you still have something to show for your efforts: the $0.9m in losses from the nine that fail is outweighed by the $1m from the one that succeeds. Now consider transactions such as these from the standpoint of an entrepreneur who is trying to raise money for his venture. Given the implied rate of interest required to equalise the attractiveness of the bond and the stock, and the crushing burden of quarterly interest payments that any rate even close to this implied rate would impose upon the company – and therefore knowing that bonds would be unattractive to investors and that banks will be reluctant (to say the least) to lend to him – the entrepreneur will almost certainly try to raise money by selling stocks (equity) in his venture.

Example #2

As a second example, imagine again that someone seeks to raise money in order to launch a business. This time, assume that (1) the chances are considerably less than 1% that it will go bankrupt within five years and (2) if it survives then in five years its equity (i.e., its net assets) will increase by no more than 10%. (Perhaps the business is a utility that supplies something, such as water or electricity, which the public regards as a necessity, whose demand is reasonably steady and whose supply is tightly regulated). Assume as well that the company’s promoter invites you to invest $100,000 in this venture. As in Example #1, assume that you are confident that you understand and can afford the risks it entails and that you wish to proceed. Should you buy $100,000 of this company’s stock or an equivalent amount of its bonds?Let us say that the promoter offers to sell you a bond. In exchange for $100,000 today, the venture promises to pay you $1,250 quarterly and in five years to repay the $100,000.

If you purchase the bond, the probability that you will recoup your investment is more than 0.99. Whether the business prospers or not – indeed, no matter how much money it makes or loses – you are entitled to no more than the quarterly payments and the return of your principal. Given the nature of this venture and the terms of the bond, there appears to be little “upside” and even less “downside.” Relative to its modest reward, in other words, the bond’s risk seems to be minimal. There is a less than 1% chance that you will lose $100,000 and a greater than 99% chance of receiving $25,000 of interest payments plus the return of your principal. As with the bonds in Example #1, so too with these bonds: their expected annualised return is approximately 5%. If the venture’s advantages are perceived to outweigh its disadvantages, and if its margin of safety exceeds that offered by other investment opportunities, then the purchase of this bond makes sense.

The purchase of this company’s stock, on the other hand, makes less sense. In the very unlikely event of failure the equity-holder’s loss is likely to exceed the bond-holder’s loss. On the other hand, in the very likely event that the business succeeds then after five years its net assets will increase by no more than 10%. Given these assumptions the stock’s expected annualised return is approximately 2%. The stock thus has somewhat more “downside” and significantly less “upside” than the bond. More generally, for any quarterly bond payment greater than $500 (and an implied interest rate of 1.9%) this business’ bond is more attractive than its stock. Because an investment in this enterprise entails very little risk, the utility can issue and sell bonds which make relatively small periodic payments (i.e., possess a low rate of interest). Because it is a low-risk undertaking, in other words, the utility need not offer the higher rates of return that investors generally demand from the ownership of equity. Investment risk, then, can vary substantially from businesses to business. Accordingly, so too does the capital structure of a business.

In general, the terms and conditions of bonds tend to reflect the risk that is perceived to inhere in the businesses that issue them. Bonds purchased at their par value can have significant “downside” but (given that their interest payments are fixed and do not depend upon the economic fortunes of the business other than its survival) tend to have modest “upside.” Hence investors tend to favour the bonds of well-established and creditworthy businesses; and the newer, less sound or more cyclical the business, the less likely that it will be able to obtain loans or issue bonds. Shares also have significant “downside.” Given that the value of one’s stake in a business correlates closely with its economic fortunes, they also possess potentially large “upside.” Hence the newer, less sound or more cyclical the business, the more likely it is that its capital will consist in equity rather than debt.

...continued in Part IV