Jeff Matthews has another
great post up today, tearing into companies who borrowed money to buy back
their own stock. (All the leverage of going private, with all the downside of
remaining public!) It got me thinking about how investment strategies, certainly
for individuals, don’t take account of dynamically changing risk profiles.
The moral of Matthews’ story is that shareholders haven’t done well by holding
onto their stock in newly-leveraged companies like Cracker Barrel, Scott’s Miracle-Gro,
Health Management Associates, and Dean Foods: they would have done much better
to sell their stock back to the company itself when it was on its buyback spree.
But here’s the thing: equity is permanent capital. Stock is meant to be something
you buy and then leave to your grandchildren, who wonder at your investment
prowess. (Look! Grandpa bought Google at the IPO price!) It’s the ultimate buy-and-hold
investment, something which should consistently produce decent real returns
over the long term. Shareholders are not meant to be one half of a
trading game, constantly trying to work out which bits of their company’s capital
structure are most attractive and whether they should rotate out of equity and
into junior debt. There’s meant to be a distinction between owners and lenders.
But that distinction is slowly disappearing. Distressed-debt funds sometimes
make their money buy buying debt low and selling the same debt high. But more
often they make their money buy buying debt low, taking control of the company
in bankruptcy, and then selling their equity in the restructured company for
a massive profit. Ever since the invention of convertible bonds, liquidity has
had a tendency to slosh back and forth between debt and equity, and sophisticated
financiers have appreciated the advantages of being agnostic as to where in
the capital structure they like to invest.
Yet individual investors, and their advisers, still very much think in terms
of stocks (long-term investments, higher-risk) and bonds (lower-risk investments
for individuals who don’t want to run much of a risk of losing money in the
market). Meanwhile, companies have been levering up and capital structures are
much more complex than the old stock-bond distinction. Preferred stock, mandatory
convertibles, mezzanine finance, payment-in-kind notes, subordinated bonds –
there’s an asset class now for any risk appetite, but none of this is easily
accessible to the retail investor.
As a result, the riskiness inherent in a simple strategy of owning stocks waxes
and wanes quite substantially. If the stock market is full of money-losing technology
stocks with massive valuations but no cashflows, it’s going to be a much riskier
place than if it isn’t. Similarly, if the amount of leverage underpinning the
stock market rises dramatically as companies borrow money to buy back their
own shares, the riskiness of the remaining shares will, necessarily, rise.
So let’s say I’m an investor in 2002, who decides that my risk profile mandates
a certain mix of stocks, bonds, and cash. If my risk profile doesn’t change
over the following five years, and my investment mix stays the same, then I’ll
end up in a much riskier place than I really want to be. As stocks lever up
and bonds tighten in, I should be selling stocks for bonds and selling bonds
for cash, just to keep the amount of risk in my portfolio constant.
But mutual funds and ETFs and the like tend not to work that way. I can buy
funds which speclize in certain types of stock, or certain types of bond –
but it’s much harder for me to buy a fund which targets not a certain asset
class (the means to an end) but rather a certain degree of risk (which is what
The financial markets have outgrown their retail investors. When will those
investors be given the tools to catch up?