Clint Eastwood captured the problem of finding value in stocks and bonds in his 1966 spaghetti western, The Good, the Bad and the Ugly. Three gunslingers go on a perilous trip to find a cache of Confederate gold left over from the American Civil War. There are bandits along the way. The gold is buried in a cemetery. As a metaphor for investing, it doesn’t get much better.
The lure of gold is what all investing is about. The “gold” in farming is tangible. You grow something or raise something, sell the crop, the herd, the milk, the eggs… and you get into the pickup and ride off to town.
Off-farm, it’s different. The vast majority of off-farm investments are intangible — shares of stocks that do not even come with certificates anymore, bonds that are also certificate-free, gold units held on your investment banker’s ledgers and participation in real estate investments documented by yet more account statements. Where is the reality?
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It lies in the future. The great investor Warren Buffett, chief of Berkshire Hathaway and master of much of the bond and stock universe, has said that a stock is worth as much as but no more than all the money it will ever make. Estimating that number is no mean trick. But we can try.
If a stock, say a telecommunications company like BCE Inc. which has earnings, then it has a ratio of price to earnings per share. For BCE, it’s 18.75. It should pay a dividend. BCE’s is 4.75 per cent. This is good. This means that if the earnings are stable and do not increase, you will get your money back in about 19 years during which time you make a nice living from dividends. This should work provided that BCE does not go the way of the bad — Nortel Networks (accounting from outer space, bankruptcy) — or the really ugly — YBM Magnex (Russian mobsters controlled this TSX-listed maker of actual magnets and bicycles). The hazards are everywhere. For safety, you need to go for the most solid stocks, the least risky bonds, and the most solid real estate deals you can find. Tangible is good, solid earnings make it better, and well-supported dividends provide insurance that even if the company goes into a slump, patience will save your financial life.
Today, you can buy the hottest things on the planet. They include many stocks high on concept, e.g., the marijuana company Canopy Growth Corp., shares of which are up about 300 per cent in the last 18 months based on no earnings, no dividends, a product that remains illegal in some jurisdictions and potential for regulation that may turn it into, who knows, something like dried milk solids priced by marketing boards. Canopy could also be like a distilling stock in the U.S. at the end of Prohibition in 1933.
You can also buy Amazon.com with no dividend, a ratio of price to earnings of 280 (yes, not a mistake, that is two hundred eighty), no dividend, and a chance to be part of a business that appears to be eating the retail world. Amazon was priced at a modest US$300 per share in 2014 and now it’s about US$1,100 per share. It has 341,000 employees, stock price volatility 1.5 that of the market as a whole and is a must-have stock for every major American equity mutual fund. However, with no dividend support, it is a pure play on the future. If earnings — and there are genuine earnings — stumble, the stock price could drop by 280 times the shortfall in expected or delivered results. This stock has a future but it is one with a lot of risk.
And what about bonds?
A bond is a promise that, if you lend some outfit money, it will pay you back and add interest at whatever was agreed to when the bond was sold. With U.S. Treasury bonds or Government of Canada bonds, the promise will be kept. The issuers will print money if they have to. With Canadian provincial bonds, there is no ability to print. But the provinces can tax. Worry about something else. With corporate bonds, you should worry.
Once upon a time, there were AAA corporate bonds, lots of them. Today, there are just two U.S. companies which have an AAA rating. They are Johnson & Johnson, maker of health care products, and Microsoft Inc., the centre of the digital universe. AAA means that nobody can imagine that it will not pay its bonds. If you go down to straight A, the future is bright. B+ is OK, B- gets people worried, C-level bonds are close to default and D bonds are in default. If you buy corporate bonds below B+, you are brave or patient or maybe a great investor sure that Kodak will turn around (it didn’t) or that Enron was no fraud (it was).
When considering a bond, always look at financial reports such as the annual statements of corporate bond issues. Make sure that the bond issue is not less than $25 million in Canada, US$100 million south of the border. Any less and the bond issue will not be easy to trade. It may not have its prices reported on bond price boards (analogous to stock tickers and online data) and may not be easily saleable without big cuts in your offering price. Further to that, if you can explain the bond’s story in a sentence, it is probably OK. If the story is paragraphs about sales forecasts and air rights for new shopping malls and explanations of how company X will soon be a hit in Indonesia, forget it. The longer the story, the crummier the bond.
Sometimes things go badly
What all this is leading up to is that for the off-farm investor prepared to throw money at things as intangible as the prospects of stock shares or bond coupon payments, cash flow is vital, distributable profits are essential and dividends sufficient to put dinner on the table are life boats when things go badly.
And they do. Consider poor General Electric. Trading at US$20 give or take, the price is about where it was in 1997. Holders have been kept alive and hopeful by the 4.77 per cent dividend but, as warning notes on many reporting services say, it may not last. Here is the word from Thomson Reuters: “General Electric Co’.s dividend may not be sustainable; the company has paid out more to shareholders over the past 12 months than it has earned.” It was a 20th century winner. But perhaps no more.
GE has endured through the Great Depression, numerous crashes and corrections. It was one of the original stocks in the Dow Jones Industrial Average in 1893. Its present return on equity is 9.6 per cent compared to Honeywell International Inc.’s 26 per cent RoE. The analysts hate it. Jet engines, electric power turbines and toasters are so old economy that almost nobody wants to hear anymore. Curiously, Amazon’s return on equity is also nine per cent, but GE has old technology and Amazon has new stuff embedded in its gigantic distribution system. It is the future. GE is the past.
Ultimately, off-farm investments are a commitment to assets you cannot touch and whose management you must trust. The more distilled the asset is from its base, the harder it is to find solid value. But to invest only in what you can see from your porch window is also risky. Your farm, its equipment, the crops, the animals and the land are tangible. The balance of assets in a diversified portfolio is intangible. Management is vigilance.