For a friend - Why are stocks the best investment instruments?

Why are stocks the best investment instruments?

Cheeky, I know; but when you think about it, there really are a few characteristics that make a good equity investment fundamentally & vastly superior than, let’s say, a bond or a commodity. Many gurus have voiced their insights before, most much better than mine; but let me reinvent the wheel one more time – more so to lay out my thoughts and to answer the question from a friend.

1. Buying power is preserved.

2. The value compounds.

3. Price-value gap can be bridged in actual practice.

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1. Buying power is preserved

- What defines a good business? Something that not only spits out net cash, but that cash is of a high % of what’s put into the business originally (i.e. high ROIC, return-on-invested-capital)

- …and as important follow-ons, it can do so over a long period of time, can ideally pass on more than the cost increases to its customers.

- If a business can do so, and pays its shareholders all of its free cash flow via dividend, then it’s fair to say that such an “income stream” increase/decreases alongside the real purchasing-power.

- Bonds certainly don’t have such a characteristic, inflation-linked / floating ones only mimic such imperfectly and are often inferior. Hard assets such as land & buildings exhibit this characteristic because they are used by businesses to generate cash-flow – and thus their value should hug the NPV of such. Commodities don’t spit out cash and is too subjected to the supply and demand.

- Hence, even without re-investment or growth, a good business should have its return at least hug the rising purchasing power of human society.

2. The value compounds

- Businesses essentially have 2 choices with their cash – either return it to equity / bond holders, or reinvest for growth.

- For a good business, the growth projects they can find often have very high returns.

- Let’s say a business has return profile of 15%, but it can constantly redeploy those returns into new, 15%-return projects. After 5 years, the per-annum return will be ~26.2% on the original investment, and it can keep on going…for a long time if the competitive & reinvestment dynamics allow (See below)

- Such a “compounding” mechanism cannot be found in any other instruments unless the investor actively reinvest the proceeds into the same investment. For example, buying more of the same bond with interest proceeds, buying new apartments with rent, etc. But for a good equity investment, it happens automatically because the good management does it for you (and vice-versa, a bad management / bad business actively destroys cash for you).

3. Price-value gap can be bridged in actual practice.

- 1 and 2 are great, but they relate to the business characteristics themselves. The magic for public equity really happens when a “price” is posted every day for anyone to purchase / sell stakes in that business.

- Because stocks = ownership of a company = ownership of future profits / free-cash-flow, a few things are notable when these ownership are exchangeable for cash among many, many people:

a. because slices of future profits are exchanged, and future is uncertain w/ many different expectations, the price of exchange in vary widely as expectation changes.

b. the company itself can participate in the exchange (secondary offerings / stock repurchase)

c. For most companies in the states, owning more stock = more influence in how the company can/should operate. If a person owns 100%, then he can do whatever he wants with the company.

- So what happens when an “inefficiency” does not get corrected and the stock remains “very cheap”? Let’s look at the example below.

- Same business as before. But this time we introduce the idea of a share price – 100 shares outstanding for this enterprise that makes $15 in year 1. Let’s say times are good, and people are willing to settle for a 6.7% return (15x earnings), so the shares are exchanged at $2.25 in year 1, and as business grew in year 2, stock goes up to $2.59.

- At that time, Jason owns 5% of the company.

- Let’s say for some reason, people all of a sudden don’t believe in this company any more – they think it will shut down in 2 years, and are willing to part with their shares at 2x PE. Stock trades down to $0.43. Disaster right?

- Let say this market perception is NOT true, what can management do?

- They can buy back shares en masse with the cash they generate, as you can observe starting in year 3. With the depressed stock price as is, let’s say this depression continues for 5 years…

- …Management could have retired 94% of the total share count by that time. At the interim, earnings / share goes up 20x due to mathematics; assuming the 2x PE holds, the stock will be 16x higher.

- And Jason would own 86% of the company. It is not hard to see that he now owns 5 out of 6 slice of this massively profitable company – vs. 1 out of 20 slice 6 years before. Jason paid ~$11 to buy a slice, but now he is entitled to ~$17 / year alone! At this point, Since Jason literally owns the company, he can privatize it, he can force dividend payouts, etc. In the real world, there are many, many ways to get paid with the company’s actual cash-flow, than to have your mood dictated by the whim (or idiocy) of other shareholders.

- And all of this is thanks to (1) the market’s mis-judgment and (2) management’s willingness and ability to act on this mis-judgment.

- In reality, before the situation gets as drastic as such, other investors would have long stepped-in precisely because of all of our greed to profit. This counter-acting mechanism is the “invisible hand” that keeps the market rational. Even when this hand fails, assuming the investors are wrong and the company can act on such misbehavior, the remaining shareholder will still be better off post-to-post as described above.

- This bridge that allows value to correct price, coupled with a corporate’s ability to generate cash and compound that cash, act as a very powerful dose of propellant that drives stock return year-in-year-out. Essentially, as long as these factors remain, there is no way the remaining shareholders lose any money besides the temporary mark.

- If such sell-off is accompanied by actual change of the business? (which is often the case. People are smart, you know)...well, that's why this game is interesting, isn't it.

* What if you are a small shareholders? Simple, you are just a passive investor and you don't matter. Like many other things in life, ha.