Monday, March 26, 2018

Equity "Coupons"

What Warren Buffett had to say about bonds and stocks in an interview on CNBC late last month:

"...if you buy a 30-year government bond, it has a whole bunch of coupons attached...And the coupon says 3%, or whatever it may say. And you know that's what you're going to get between now and 30 years from now. And then they're going to give you the money back. What is a stock? A stock is the same sort of thing. It has a bunch of coupons. It's just they haven't printed the numbers on them yet. And it's your job as an investor to print those numbers on it. If those numbers say 10% and most American businesses earn over 10% on tangible equity. If they say 10%, that bond is worth a hell of a lot more money than a bond that says 3% on it. But if that government bond goes to 10%, it changes the value of this equity bond that, in effect, you're buying...when you buy an interest in...anything, you are buying something that, over time, is going to return cash to you...And those are the coupons. And it's...your job as an investor to decide what you think those coupons will be because that's what you're buying. And you're buying the discounted value. And the higher the yardstick goes, and the yardstick is government bonds, the less attractive these...look. That's just fundamental economics. So in 1982 or '83, when the long government bond got to 15%, a company that was earning 15% on equity was worth no more than book value under those circumstances because you could buy a 30-year strip of bonds and guarantee yourself for 15% a year. And a business that earned 12%, it was a sub-par business then. But a business that earns 12% when the government bond is 3% is one hell of a business now. And that's why they sell for very fancy prices."

An emphasis on stock prices -- how they'll change over short or even more extended time horizons -- is best thought of as speculation (if not pure gambling). There's nothing inherently wrong with speculation, of course, it just has less in common with investing than some seem to think.

If, instead, the emphasis is on what the "coupons" will look like long-term it's possible, if not easy, for a present valuation, within a narrow enough range, to be estimated. From there prevailing market prices can be compared to estimated value. Sensible investment decisions can then be made.
(Based upon, best case, inescapably imperfect but meaningful assumptions.)

Two or more informed investors will rarely agree, at least not in a precise way, on the intrinsic value of an investment. It's not about being right; it's about being right enough within an acceptable range.

Judging what the equity "coupons" are likely to be over a long time frame is challenging enough. Predicting interest rates is, if not impossible, nearly so. The discount paid to a conservative estimate of value can, only up to a point, protect the investor from errors, unknowns, and the unknowable.

Margin of safety always comes into play; deciding what it should be is necessarily investment specific.

Stretch assumptions and investing well just aren't compatible.


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