Investing In Stocks, Bonds, Funds: What Are We ‘Betting’ On?

The “Roaring 20s” – Then and Now

Back in the 1920s most investors thought the stock market was a big gambling casino, with little underlying rationale for stock price movements beyond changes in the fickle and unpredictable whims of the investing public.

The publication of Benjamin Graham and David Dodd’s landmark book, Security Analysis, in 1934, introduced the analytical framework we still use to value stocks and to identify those that Graham’s “Mr. Market” mis-prices too cheaply, and which represent “value” to potential investors. Prior to this, with no theory of value to explain or justify price levels, when crashes and panics occurred, like in 1929, they were harsher than ever because there was no rationale for buyers to identify value and swoop in to pick up bargains.

About the same time, an economist named John Burr Williams published his lesser-known but profoundly important book, The Theory of Investment Value (1938), that introduced the idea that a security’s economic value was the discounted present value of its future cash flows (all the dividends and interest it would ever pay, plus its terminal value when ultimately sold or repaid).

Graham & Dodd’s and Williams’s ideas together showed the world, first, how to analyze a company’s earnings and cash flows, and then, having done so, how to value them. These concepts underpin many of the mainstream investment strategies developed over the next 80 years. Our Income Factory® strategy draws heavily on Williams’s basic theme, especially that “cash flows are cash flows,” whatever their source, for purposes of calculating an investment’s value; so distributions and dividends count just as much as market price growth in determining an investment’s “total return.”

From Theory to Practice

Just because we analyze a company and determine what we think its earnings and cash flows are likely to be, and how we expect a rational market might value those earnings and cash flows, that doesn’t ensure that our expected scenario is actually going to happen.

Here is where it gets interesting. When we buy the security – stock, bond, convertible, option, etc. or a mutual fund (closed-end or open-end) that owns a whole bunch of securities – we are making a bet that a certain scenario will actually occur. If the scenario plays out, then we win our bet. If it doesn’t, then we lose our bet.

It sounds simple, and it is. But because it is so simple, a lot of investors don’t really think about it and overpay or leave money on the table by not fully appreciating the bets they are making when they buy certain securities or asset classes.

Take the simplest investment anyone might make, like opening a checking or savings account. When we do that, our expectation is only that we will get our money back whenever we want it. Sometimes with a minuscule interest payment along with it. What is our bet? That the bank or savings & loan won’t go bust while holding our money, and that we’ll actually get it back when we want it.

In an age of deposit insurance and government regulation of banks and similar institutions, that’s a pretty simple bet, one we don’t even think about when we open the account.

Loans – Top of the Capital Structure, Least Risk

But let’s move up the food chain of risks to a loan to a corporation. Banks make loans (usually secured by collateral) to corporations all the time. If it is a large loan to a major corporation, the bank often underwrites the loan and syndicates pieces of it to other banks and institutional investors like pension funds, endowments, collateralized loan obligations (“CLOs”), etc. Retail investors, like us, can buy into this market primarily through closed end funds, like Blackrock Debt Strategies (DSU), Invesco Senior Income (VVR), Eaton Vance Floating Rate Income (EFT), etc.), or ETFs like Invesco Senior Loan (BKLN) or SPDR Blackstone / GSO Senior Loan ETF (SRLN).

What are we betting on when we buy a corporate loan? Or a portfolio of these loans, whether it is a fund or an ETF? We are betting that the issuer (or all the issuers, if it is a fund or ETF) will survive and not go bust; that it will continue in business and pay its debts, interest and principal, as they come due. I call this the “existential” risk (although bankers call it “credit” risk; same thing), the risk of the issuer going out of business.

Investors who buy high yield corporate bonds – funds like BlackRock Corporate High Yield (HYT) or KKR Income Opportunities (KIO), etc., or ETFs like iShares iBoxx $ HY Corporate Bond ETF (HYG) – are making the same bet as corporate loan buyers, that the issuing companies will survive and pay their debts.

In both cases – secured lenders and unsecured bond and note holders – they win their bets (i.e., get their money back with interest) as long as the company survives and repays its debts. The only difference is how much each loses if the company fails and they lose their bet. Loan investors almost always have security and are therefore at the front of the line for payment in a bankruptcy. So they may only lose a relatively small percentage of their investment (perhaps 25%), since secured loan creditors historically have recovered about 75% of the principal. Unsecured creditors, like bond and note holders, have tended to lose at least twice as much, with average recoveries historically only about 40-50% of the principal.

That’s why we expect funds that hold corporate bonds, as opposed to loans, to pay a higher yield. The funds we own that buy high yield corporate bonds, for example, typically pay distribution yields a percentage or two higher than our senior loan funds.

Equity – Bottom of the Capital Structure, More Risk

Unlike credit investors (loans, bonds, etc.), equity investors are betting the company will not only survive and pay its debts, but will also thrive and grow: that it will increase its earnings and dividends, and that the market will take note of that and then increase the stock price accordingly.

That means equity owners take the same existential (i.e., credit) risks that the company will fold that creditors above them on the balance sheet are taking, since if an issuer defaults on paying its debts, then the company goes bankrupt and the equity investors below them have nothing. (Sometimes in a complex bankruptcy the equity owners will get some scraps from the negotiating table to buy them off so they won’t drag out the process through endless litigation, etc.)

But equity investors are also making an “entrepreneurial” bet, which is more than just the company’s surviving and paying its debts. It’s a bet that the company will thrive and grow its earnings and, ultimately, its stock price. If all the company does is stay alive, but fails to grow, then equity investors will lose their bet.

With no growth of earnings, there will be no reason for the issuer’s stock to increase, so the investment will likely be dead in the water. The investor won’t necessarily lose principal, like a creditor who doesn’t get back their principal when an issuer folds. But they probably won’t get any growth so their only income will be the dividend, which for most growth stocks is only 1-2%, not what the investor was bargaining for when they made the bet to begin with.

Obviously, there are some mature companies – utilities, REITs, etc., – with high dividend yields where most of the anticipated total return is in the dividend itself and little additional growth is required or expected. In these cases, the investor’s “bet” is actually more like a creditor’s bet than a typical equity bet in that all they are actually expecting (and betting on) is the company’s ability to continue along its current path and pay its existing dividend indefinitely.

Comparing the 2 Risks: Finishing the Race vs. Winning It

I frequently compare the two investment bets, the “survival” bet (i.e., credit/existential) vs. the “thrive and grow” entrepreneurial bet, to horse race gambling. The credit bet is like betting on a horse to merely finish the race. All it has to do is make it around the track without collapsing and you win your bet. The equity bet is like betting on your horse to win, or at least to place or show; in other words, do better than the average horse and finish close to the front of the pack.

Obviously, the credit bet (finish the race) is a much easier bet to win than the equity bet (win the race, or at least come close).

The More Risk, The More Reward – At Least In Theory

If equity investors are taking both–

1. The exact same risk that credit investors take, that the company won’t survive and “finish the race,” and at the same time
2. The additional risk is that the company won’t thrive and grow in order to make itself and its stock more valuable….

then they should be paid MORE than credit investors, who only take the first risk, but not the second. If they are not getting paid more, then maybe they should ask themselves “why not?” and re-think their investment strategy

Personally, I like to phrase the question as more of an opportunity:

• If I can find a way to make an “equity return” by ONLY taking existential (i.e., credit) risk on the same cohort of companies, then why wouldn’t I adopt that as my preferred style of investing? In other words, why should I take on additional risk if I’m not being paid more to do so?
• Aha! “Equity Returns Without Equity Risk”

This concept – Equity Returns Without Equity Risks – is at the heart of our Income Factory® strategy.

Historically the S&P 500 and other broad measures of stock ownership have averaged 9 or 10% total returns over the past century. What if I can achieve that, or close to it, by taking mostly credit risk or “near credit” risk that is less risky than typical equity risk? “Near credit” risk is what I consider high-yielding equity issuers (REITs, utilities, BDCs, covered call strategies, etc.) where we seek steady-Eddie performance at their existing level, rather than “growth.”

I use mostly closed-end funds and similar high-yielding vehicles (like business development companies, i.e., “BDCs) to implement my strategy. While I don’t necessarily expect to beat a long-term buy-and-hold equity strategy, I have found (and thousands of readers, followers, and subscribers now seem to agree with me), that collecting practically our entire total return of 8-10% in the form of cash distributions, that we can reinvest and compound at bargain prices when prices drop, allows us to hang tight and sleep better at night during market downturns. That’s because we know our income stream (the “output” from our Income Factory) grows faster than ever when we reinvest during downturns at lower prices and even higher distribution yields.

History has shown conclusively that “time in” the market is a much more effective strategy than “timing” the market. So having a “river of cash” to buffer the rough periods, while traditional growth investors are collecting their puny 1% or 2% dividend streams while they watch their prices drop, is a psychological advantage as well as a financial one.

The recent 2022 first quarter demonstrated that as our two model portfolios suffered total returns in the same negative 5-6% range as the S&P 500 (SPY), but while SPY investors were only collecting dividends at a 1.3% annual rate, our two Income Factory model portfolios were cranking out distributions at 8% and 9% rates, respectively, that we are re-investing at today’s bargain prices and yields.

Conclusion

The idea that a credit bet is very different – and safer – than an equity bet seems like it should be an obvious one. But I am constantly reminded of how many people do not fully appreciate the idea, when I get comments from readers who say they would “never” own high-yield bonds or loans because they are so “risky.”

“High yield,” of course, refers to issuers that are rated below-investment grade (BB+ and below) and includes the majority of all corporations, including almost all syndicated corporate loan issuers. Ironically, many of the investors who swear they’d never touch “high yield” bonds or loans already have stock portfolios chock full of mid-cap and small-cap equity funds, the same cohort of non-investment grade companies that issue the high yield debt they say they’d never buy.

Don’t these investors realize this equity would be worthless if the debt they characterize as so “risky” were to default? (Of course, I’m not arguing that such debt is “too risky” since historically it has a very solid record, but am merely pointing out how naive or inconsistent such a position may be.)

Of course, it is misconceptions like this that create the inefficiencies that closed-end funds and other smaller, less appreciated markets allow investors like us to take advantage of.