A Short Guide to The World of Financial Investments. Part Three
Why the Value of Paper Money Returns to Zero, What Is the Value of Things, and Why a Good Sketch Is Better Than a Long Speech
What It Is, Why You Should Do It and Where to Start
In the second part of this short guide, we found out what is the basic principle of successful investing: you need to figure out the real value of something and then pay a lot less. So, what is the value of things?
The fundamental theory of finance says that the cost of any financial investment depends on the accumulated amount of current and future cash flows from this investment. What kind of cash flows can we expect from investments in various financial instruments? We have already mentioned that bonds are, in fact, market-traded loans issued to governments or companies. That is why, when purchasing a bond, we can usually expect to receive fixed periodic payments (bond coupons) as well as the principal or face amount of this bond when it is redeemed. When investing in stocks, we expect to receive dividends, as well as the amount that can be obtained from the sale of these stocks at some point in the future. It should be noted that, unlike bonds, neither the size of dividends nor the future selling price of stocks is fixed. When investing in real estate, we can sometimes expect to receive a certain rental income. But we also should bear the regular costs of maintaining a property in working order, while the future selling price of this property is uncertain too. When investing in commodities, we do not receive any income at all, while incurring certain costs associated with their storage. In this case, we may hope to gain from a rise in the future price of commodities.
From the above explanations it becomes obvious that the cash flow associated with the purchase of the bond is more stable since both its periodic coupon amount and its final redemption amount to be paid to us are known in advance and, in most cases, are fixed. Consequently, the price of the bond is more stable compared to other instruments. It also follows that the prices of stocks or properties that provide a stable payment of dividends or rental income are more stable compared to other stocks and real estate investments. But this does not mean that their final selling price in the future will be higher. It is also clear that the maintenance costs for properties or the storage costs for commodities have a negative impact on the prices of these assets. In any case, for stocks, properties, and commodities, their selling price in the future plays a decisive role. That is why the slightest changes in expectations and forecasts regarding these selling prices in the future have a direct impact on the prices of these assets today.
Still, the simple addition of a sequence of cash flows from different time periods is not appropriate since “paper money eventually returns to its intrinsic value — zero”, as the famous French philosopher Voltaire put it. That is why the fundamental theory of finance also asserts that the cash flows received in the future have less real purchasing power compared to the cash flows received today. Scientifically speaking, the value of a financial investment depends on the discounted cash flow that we can expect to receive when making this investment (see Picture 3.1 and 3.2 below). Discounting, or value reduction, occurs by using interest rates. Interest rates consist of three components: first, a risk-free interest rate that reflects the time effect between consumption today and consumption in the future. It is usually paid by the most trustworthy borrowing governments; second, a market-risk premium paid by all private companies since they carry a higher risk of not meeting their obligations when compared to the governments; third, a specific-risk premium paid by each specific company.
Since the amount of bond coupon payments and its redemption (principal, face) amount are fixed, it can be concluded that changes in its price are almost entirely explained by changes in the interest rate used to discount the bond’s expected cash flows. However, these changes can occur for various reasons. The changes may occur due to an increase in the risk-free interest rate delivered by the central bank in an effort to fight high inflation. There might also be a rise in the market-risk premium due to some economic or political upheavals, for example. Or there might be a rise in the specific-risk premium for a particular company due to any negative events that have a direct impact on its operations. Still, the general conclusion is straightforward: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
As far as stocks, properties or commodities are concerned, the situation gets more complicated. This is due to the fact that the amount of dividends and rental income as well as the final selling price of stocks, properties and commodities are not fixed, unlike bond coupons and bond redemption prices.
If a rise in interest rates occurs due to rapid economic growth, booming domestic and foreign demand, or rising company profits that lead to higher inflation (“demand-pull inflation”), then we may also observe rising stock, real estate and commodity prices during such periods (see Picture 3.3 below). This may happen because corporate profits can outpace inflation, as was the case during the boom years before the global financial crisis. If high inflation is the result of rising commodity and semi-finished product prices as well as labor costs, for example, when we encounter difficulties in sourcing raw materials or experience interruptions in supply chains of certain intermediate products or there is a shortage of workers (inflation induced by rising corporate costs, “cost-push inflation”), then companies commonly end up facing declining profits in these cases. Raising interest rates to fight this type of inflation may further aggravate the situation. That is why stock and real estate prices usually experience a downward pressure in such instances, while prices for “scarce” commodities tend to rise (see Picture 3.4 below). This could have been observed during the period of stagflation in the 1970s and early 1980s when there were high rates of inflation and low rates of economic growth.
If interest rates remain stable, then the growth rates of corporate profits and dividends, as well as the growth rates of real estate rents obviously have a positive impact on the growth rates of stock and real estate prices (see Picture 3.5 below). It should be pointed out, however, that many companies have not paid dividends in recent years. Instead, they opted to buy back their shares on the market with the aim of “optimizing” tax costs faced by companies or investors. If the dividend tax rate exceeds the capital gains tax rate, for example, then it is more profitable to repurchase shares rather than to pay out dividends. This does not change, though, the bottom line since both outcomes are positive for investors.
However, the period preceding the global financial crisis of 2007–2009, when we were observing rapidly rising prices for most assets, clearly demonstrated the role of psychological factors. The essence of these psychological factors is very well reflected in the expression of the ancient Roman author Publilius Syrus, “Every thing is worth what its purchaser will pay for it” (see Picture 3.6 below). In other words, the psychological branch in finance (“behavioral finance») argues that, first, humans are not robots and are rather “semi-rational” beings who do not make decisions based only on rational, fundamental factors; second, humans are biological and social beings who also make decisions based on biological and social factors, for example, by reacting to a certain level of hormones in the body or by following some trends (“traditions”, “fashion”) that dominate in his or her social environment; third, for humans psychology is more important than fundamentals, so a successful investor devotes time to analyzing the behavior of other investors rather than studying the fundamental value of companies.
Still, there are people who do not pay any particular attention to either fundamental or psychological factors. They simply devote their time to studying stock price charts following Napoleon’s principle that, “A good sketch is better than a long speech” (see picture 3.7 below). In other words, these investors rely on technical analysis. They justify this approach by arguing that, first, all information about a company (profit and dividend expectations, its prospects and outlook, etc.) is already reflected in its stock price. As a result, it can be extracted by studying company stock price charts. Second, they also rely on the principle that “history repeats itself” and prices tend to follow some trend. Why is this happening? Because under the impact of “herd mentality” people tend to join the prevailing trend. Third, access to fundamental information is not uniform and its dissemination occurs only gradually. Any important information about a company is initially absorbed by insiders, who are followed by financial market professionals. Non-professional market participants are the last ones in this information dissemination line (or “queue”, as our British friends would say).
To sum up, technical analysis suggests (see Picture 3.8 below) that, first, stock prices sometimes indeed follow some trend. You can say that they exhibit some inertia. This is used in a momentum trading strategy whose proponents argue that rising prices will keep on rising. Second, ultimately prices sometimes indeed revert to some average level. This argument is used in mean reversion strategies. Third, stock prices sometimes indeed exhibit certain seasonality. Fourth, stocks with lower P/E (price/earnings) ratios sometimes indeed show better price performance. Fifth, stocks with higher initial dividend yields sometimes indeed demonstrate better price performance. However, you should bear in mind that all the above rules work only “sometimes” rather than “always”.
What are the practical implications for our decision making when determining the value of a stock from long-term and short-term perspectives?
Principle №1 says that in the long term we should rely on fundamental and psychological factors while bearing in mind that, “In the long run we are all dead”, as John Maynard Keynes, a famous economist and investor, put it (see Picture 3.9 below). This basically implies that when making a long-term investment we should remember that our assumptions should be realistic since in the long term many things can change drastically. For example, when we read what was expected to happen in the world of technology over the last ten years, then we can conclude that these predictions mostly proved to be too optimistic. And in 90% of cases large infrastructure projects are implemented with delays. It would be prudent to assume that nowadays a period of three to five years can be considered as “long-term”.
Principle №2 says that when making short-term investments — or speculative transactions, if you will — you should rely on technical analysis as well as psychological factors, while bearing in mind that, “Markets can remain irrational longer than you can remain solvent”, as also stated by Keynes. In practice, this means that you should cut short unsuccessful trades to avoid the situation where your investment portfolio is just the remnants of failed speculative transactions and trading positions. Building your long-term financial well-being may become a major challenge under these circumstances.
And which investment strategy is likely to be efficient in delivering good results in the long term? To be continued…
