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The Stock-Bond Relationship
Like Robinson Crusoe on his island, an investor’s primary goal is to maintain the purchasing power of his capital. In practice, this means that the investor’s portfolio must generate a stream of income that over time is sufficient to maintain his standard of living. Given the achievement of this primary goal, the investor’s secondary goal is to increase the purchasing power of his capital, i.e., to generate a stream of income that, like Crusoe I and Crusoe II, increases his standard of living over time.
One way to proceed – not so much as a specific method but as a general point of view – is to compare a “risky” security (A) to a benchmark and “risk free” security (B). Simple but rigorous methods such as those described in Part IV and Part V can help to ascertain whether a particular “risky” security (i.e., stock, corporate bond, etc.) is likely to constitute a better or worse investment than a “risk free” security. Comparing their respective “coupons i.e., the money that each generates (or can reasonably be expected to generate) per year, the particular security is more attractive when its yield exceeds the government bond’s and its coupon (and hence its yield) can reasonably be expected to grow vis-à-vis the bond’s coupon.
This comparison allows the investor to determine whether the price and assumed rates of growth of a “risky” security A’s coupon are plausible or unrealistically optimistic. The investor’s primary objective – through successive comparisons, much more detailed analysis, many “rejections” and some “acceptances” (see Value Investing, Risk and Risk Management) – is thus to accumulate a portfolio of assets whose coupons can reasonably be expected to exceed by a significant margin the “risk-free” coupons of government bonds. As Mr Graham and Mr Buffett have emphasised for decades, the more difficult it is to do so the more sensible it is to plough capital into short-term bonds or their equivalents. Hence Graham’s injunction to buy stocks whose current yields exceed that of government paper. The secondary and much more challenging objective is gradually to acquire a portfolio whose stream of earnings matches or surpasses a much stiffer threshold, i.e., the natural rate of interest.
Time Is Money: Investment Return and the Payback Period
Hitherto (and purposefully) very little has been said about the calculation of investment returns. On the basis of the principles, analyses and conclusions in Parts I-V, however, much can now be said. Not surprisingly, little or none of it will resonate with the financial mainstream. If, as Benjamin Franklin advised, time is money, then the return on an investment can – indeed, should – be measured in terms of time as well as money.
An implication of our analysis is worth making more explicit: even when variable stream of coupons (such as those from a share) cumulate to the same amount as fixed stream of coupons (such as those from a bond) an investor is unlikely to regard them as equivalent. Would you be equally as likely to enter two occupations with the same expected income – say $50,000 per year – over the next decade if one occupation paid $50,000 every year whilst the other paid $20,000 with a probability of 0.50 and $80,000 with a probability of 0.50? It is likely that you would require a higher expected income from the occupation with variable pay in order to make it equally attractive to the occupation with fixed pay. Hence the “risk premium,” i.e., the additional increment of income that you require from the variable stream vis-à-vis the “guaranteed” one in order to render the two streams equally attractive. Accordingly (given their innate characteristics and risk profiles), stocks usually have a higher yield than corporate bonds; and corporate bonds, in turn, usually have a higher yield than comparable Australian Government bonds.
The degree of investment risk that inheres in a given asset varies not only with the variability of its coupons: it differs as well according to the “payback period” required to recoup one’s initial investment. The payback period of the Telstra share analysed in Table 1 (Part IV) is approximately 12 years, and that of the Commonwealth Government bond to which it was compared is slightly more than 16 years. Table 4 shows why. Given our assumptions (i.e., Telstra’s purchase price of $8.20, coupons grow at 17% per year), 12 years is required for the cumulative coupons to meet or exceed the asset’s purchase price. Twelve years, in other words, is required – assuming that the coupons eventuate according to this trajectory – for the Telstra share to “pay for itself.” Analogously, slightly more than 16 years are required for the bond to pay for itself.
Table 4: Comparing Payback Periods of the “1999” Stock and Bond
| |
Telstra Share at $8.20 With 17% Growth of Coupon |
6.35% Government Bond With
Fixed Coupon |
| |
Coupon |
Cumulative
Coupon |
Coupon |
Cumulative
Coupon |
| Year 1 |
$0.27 |
$0.27 |
$0.51 |
$0.51 |
| Year 2 |
$0.32 |
$0.59 |
$0.51 |
$1.02 |
| Year 3 |
$0.37 |
$0.96 |
$0.51 |
$1.53 |
| Year 4 |
$0.43 |
$1.32 |
$0.51 |
$2.04 |
| Year 5 |
$0.51 |
$1.90 |
$0.51 |
$2.55 |
| Year 6 |
$0.59 |
$2.49 |
$0.51 |
$3.05 |
| Year 7 |
$0.69 |
$3.18 |
$0.51 |
$3.56 |
| Year 8 |
$0.81 |
$3.99 |
$0.51 |
$4.07 |
| Year 9 |
$0.95 |
$4.94 |
$0.51 |
$4.58 |
| Year 10 |
$1.11 |
$6.05 |
$0.51 |
$5.09 |
| Year 11 |
$1.29 |
$7.34 |
$0.51 |
$5.60 |
| Year 12 |
$1.52 |
$8.86 |
$0.51 |
$6.11 |
| Year 13 |
|
|
$0.51 |
$6.62 |
| Year 14 |
|
|
$0.51 |
$7.13 |
| Year 15 |
|
|
$0.51 |
$7.64 |
| Year 16 |
|
|
$0.51 |
$8.15 |
What is an appropriate payback period? First, note in general that the longer the time required to recoup an investment, the riskier that investment becomes. The longer the payback period, the more a decision to invest depends upon its underlying assumptions, i.e., the more imperative it becomes that those assumptions correspond to reality. With each additional year of waiting, the chances increase that unforseen or uncontrollable factors – a recession, a decrease of the purchasing power of the currency, new competition, the loss of key contracts, employees and innumerable and perhaps unimaginable factors – will decrease (or halt the rate of increase of) the size of the yearly coupon and hence prolong further the payback period. What are the chances that during the next dozen years the Australian telecommunications industry will change significantly and in some unforeseeable way? Second, note that a natural rate of interest of 12-15% and a constant stream of coupons implies a payback period of 6-8 years. For these reasons, the Telstra share’s shorter payback period (under the assumptions in Tables 1 and 4) does not imply that it is attractive in an absolute sense. Both payback periods greatly exceed that implied by natural rate of interest in Australia; and by this absolute, more challenging (and virtually unknown) yardstick neither of these investments nor their associated assumptions are compelling.
....continued in Part VII
 
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