Monday, June 05, 2006
As I lay in bed on Black Monday night, questions ran through my mind, each one leading to another. I knew I needed an overarching investment strategy that would guide my clients and me in the days and months ahead. I remember thinking I couldn’t drive the race in front of me and read the roadmap at the same time. Tomorrow morning I had to speak to the firm’s brokers by conference call about what Black Monday meant in the short and longer terms. I knew about half of what I was going to say: Black Monday was a financial accident. The value of Corporate America was unchanged except for whatever lingering effects the crash may have had on consumer confidence. The market may have been overvalued heading into Black Monday, but the crash was the result of computer trading gone out of control. I believed completely that Black Monday was an accident, but I knew after I gave my explanation, someone would invariably ask if it meant that we should start buying, and if so, what should we buy. I had come to that question dozens of times since the close of business and had been left with only question marks. I did not know how bad the financial accident was, or how strong the aftershocks would be. I only knew there would be aftershocks; the market is never neat and orderly as it tries to make a bottom. As I kept asking myself what was safe to buy, I remembered my purchase of the Indiana University bonds. I had received a yield above 9% completely free of all taxes and backed by one of the most conservative states in the union. If that wasn’t a good buy, then what was? Bonds are it. Tomorrow morning I was going to take my turn at the microphone and tell the firm’s brokers to buy municipal bonds. Everyone wanted to know what stocks to buy, but it just did not feel right to me yet to be jumping into the stock market until the bottoming process was further along. With my comments for the next morning put to rest so to speak, my mind turned to a recap of the people I had spoken with throughout the day. I had made and received scores of calls, but the calls from Mrs. H, my friend with the IU bonds, and Billy T. resonated inside of me, still. Somehow I knew they were seminal and would, ultimately, reshape my understanding of investing. I did not know everything these three calls meant, but as I thought through them I realized that in each case it was as though something was speaking to me, even though I was the one doing most of the talking. When I had some free time, I knew I had to dig deeper into what had gone on in each call. For now, the call from my friend who wanted to sell the IU bonds took front stage. As I replayed the events surrounding the purchase of the bonds, I was both delighted and indicted. I was delighted because I realized that I had bought a substantial amount of bonds without the benefit of knowing exactly where the market for them was trading. I had evaluated the bonds, put a price on them, and said I was willing to buy them when bond traders at most bond desks around the country had passed. In retrospect, I realized that in the midst of all the unknowns something kept telling me to “do the math”; to get that right and everything else will take care of itself. I was indicted because I had been in the investment business for 12 years with two different firms, and today I realized I did not know how to value a stock apart from its selling price on the exchange. If the stock markets had been closed and somebody would have called and wanted to sell me some General Electric common stock, I would have laughed at them. It was impossible. Prior to Black Monday, in my mind the market price dictated what a stock was worth. After all, the market was efficient wasn’t it? That is what I had been hearing for nearly a decade. The price of a stock reflected the collective decisions of millions of buyers and sellers, which produced a sort of “handicapping” similar to what goes on in horseracing. The best horses, while offering a high probability of being “in the money,” paid very little for a win. On the other hand, horses with poor track records and thus, not having a high probability of winning, paid big odds when they did win. Stocks were like horses weren’t they? The odds – prices – were always right, right? But on the night of Black Monday, I realized the notion that the market (the bettors) always puts the right price on a stock was nonsense. The average stock had fallen 23%. It was utterly clear that investors were not trying to make informed decisions about the value of companies; they were just running from the fight. I was convinced of that, but I knew no math that could pinpoint which stocks were the best values. As these thoughts circled through my mind, I realized that the “math” for the bond purchase was not as easy as I had originally thought. The interest rate on the IU bonds was 7.5%, and I agreed to buy them to yield 9.4%. Bond traders use special bond calculators to compute cost from yield or vice versa. I had no bond calculator, thus, I used a “rule of thumb” method to compute the approximate price for the IU bond. The current yield of a bond is current income divided by price. This simple formula works if you are paying par (face value) for the bond, which is usually $1000. However, if you are buying a bond in the secondary market, it might be selling for more or less than the face amount, and thus, you need to make a calculation that takes into consideration any capital gain or loss the bond may realize during the holding period. The term “yield to maturity” is used to describe this adjusted rate of return for a bond. With an interest rate of 7.5% and a yield to maturity of 9.4%, it was obvious that the IU bond’s additional rate of return would come from buying the bond for less than its maturity value of $1000. That would mean that when the bond matured (paid off) it would produce a capital gain, which when added to its interest rate would total 9.4%. As I dozed off, the last thought I remember thinking was is it possible to use the rule of thumb method of valuing a bond to value a stock? Was it possible to turn stocks into bonds? Note: It has taken us three weeks to reach the end of Black Monday, yet this is not a story about Black Monday but of Rising Dividend Investing. From this point on, I will quicken the pace of explaining my search for methods of determining the approximate value of a stock. This may be of particular interest in light of the recent fall in stock prices. Has the value of corporate America really fallen 5% in recent weeks? Do the stock traders –bettors – have it right, or are they just betting the jockey’s colors. Our stock market model is saying that the value of corporate American is on the rise, not decline.
Labels: The Rising Dividend Story