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Looking at Stock Investments
From a Fixed Income Perspective
David P. Kirch, PhD, CPA
“It’s all in how you look and
study on it.”
Brother Dave Gardner
Acknowledgements
This is a work in progress. I would like to thank my wife Chris for her many insights
comments on an earlier draft. If you want your name here, help me out!!
1
Looking at Stock Investments From a Fixed Income Perspective
One of the greatest menaces to a retirement plan is the misunderstanding of the fixed income
market. This includes savings accounts, certificates of deposit, bonds and so forth. These
investments are classified as ‘fixed income investments’ because the amount earned is fixed at a
certain amount or rate. Thus, if you put $1,000 in a savings account paying 1% per year, you will
earn $10 per year on that investment regardless of what happens to the economy, the stock
market or interest rates. Throughout this paper we will use bond investments1 as a surrogate for
all fixed investments.
This confusion by investors over the nature of fixed income investments is especially insidious
because investing in bonds over the last 50 years would have gotten you an average return of
5.07% while investing in the stock market, as measured by the return on the S&P 500, would
have returned 9.89%! To put this in perspective, investing an equal amount in your retirement
plan using stocks during that same period would have allowed a retirement on twice the annual
income that investing in bonds would allow you.
The downside to stocks as far as most investors are concerned, is the volatility. If you have a
bond that is paying you 4%, then you are earning 4% no matter what happens to the stock
market, interest rates or to the economy2. But this is not entirely true. It is true as far as focusing
on the return is concerned, but it ignores fluctuations in the interest rates. Let me explain. Let’s
say you bought a $100,000, 10 year, 5% bond with the interest payable annually. Over the ten
years you will certainly earn your 5% face rate per year. But what if the interest rates change?
You will get your 5%, but what will the value of the underlying value of the bond you invested in
be? The table below shows the changes in the value of the underlying bond based on changes
in interest rates.
Face
Rate
5%
5%
5%
5%
5%
5%
5%
5%
5%
5%
1
Current
Rate
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
$
$
$
$
$
$
$
$
$
$
Face
Principal
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
100,000
$
$
$
$
$
$
$
$
$
$
Current
Value
119,414
114,140
109,159
104,452
100,000
95,788
91,800
88,022
84,441
81,046
Bonds are debt of companies or governments. They are normally issued such that the investor get a certain return
over the period from their issuance until they come due.
2 For the purposes of this article we are ignoring the economic risk of the investment. If there were dramatic shocks
to the economy or the individual company, it is possible that the company which issued the bonds you invested in,
could be severely affected, even to the point of bankruptcy. This would magnify the differences presented in this
paper.
2
Note that changes in interest rates can cause large changes in principal values. Increases in
current interest rates cause decreases in the value of the underlying bond and decreases in
current interest rates cause the opposite. An increase in interest rates from 5% to 6% causes a
decrease in the value of the bond investment of $4,212.3 A decrease in interest rates from 5% to
4% would cause an increase in the value of the underlying bond of $4,452 (from $100,000 to
$95,788). Most investors consider these changes in the value of their bonds irrelevant since they
are still earning their 5%. You would look at an investment in an apartment building or similar
investments in the same way. What is the income you expect from the tenants? The value of the
actual property is only a consideration if you plan on disposing of it.
This paper proposes that a person can use this same reasoning to train their brain to look at the
stock market in a similar fashion. This would allow a person to mentally ignore the ups and
downs of the stock market. After all, the ups and downs of the stock market are simply changes
in the value of the stocks, in other words, changes in the “principal”. You will train yourself to
focus on the returns and only consider the current stock price if you are thinking about selling it.
This will allow you to comfortably ignore day to day volatility in the market and the accompanying
anxiety. This decrease in anxiety would allow you to more comfortably enjoy the higher returns of
the stock market and still sleep comfortably at night.
Again, we ignore volatility in the bond market simply because the focus is on the return rather
than variations in the underlying value of the bonds. So we are now going to refocus our
attention on the return of the stock market rather than the price of the shares. We will not
address the actual selection of the stocks. We will use a sample of stocks from the S & P 500.4
To calculate the return we are earning on our stocks, we have two possible choices: the earnings
of the company or the dividends the company is paying. Both have advantages. We will deal
with the second first. Dividends are real returns. We can spend them and, really, they are the
reason we buy a stock. In the long term, the only value of a stock is in the dividends it pays. As
Warren Buffett says, “If a financial asset were valued properly, they would all sell at a price that
reflected all of the cash that would be received from them forever until Judgment Day, discounted
back to the present at the same interest rate.”5 As applied to a stock, this simply means the
value of the stock is the present value of all future cash flows, that is, of all future dividends. So
this would seem to end the argument, we will use dividends. But…….
There are some real problems with using dividends as the driving force in the value of a stock.6
First, dividends are a product of earnings. So to project dividends, you need to project the
earnings. From that projection, you need to project how much of these earnings the company will
pay out as dividends. This last calculation is known as the “payout ratio”. For a few companies
this last calculation has proved to be very stable over the years. These companies, though, are
3
We are assuming that the changes in interest rate on your bond are the result of market conditions, not some
problem in the company issuing the bonds.
4 We are ignoring mutual funds and assuming that you judicially select stocks which will mimic or beat the S&P 500.
Mutual funds are ignored because the vast majority of them do much worse than the S&P 500. See “Mutual Fund
Performance”, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=955807 for example. Actual methods of
selecting stocks to invest in is covered in http://aspnet.cob.ohio.edu/isms/cobcontent.aspx?5688.
5 Fortune magazine, November 9, 1998 pp. 173–178.
6 Many models, such as the Gordon Growth Model and the Dividend discount model do use dividends to measure
the value of a stock.
3
a small part of the stock universe. Many of the more attractive stocks are still reinvesting all their
profits in their own growth and are paying minimal or no dividends to the stockholders.
Valuations of these using the any dividend model requires extremely tenuous assumptions.6
Another problem that has become especially pertinent lately is the rash of stock buybacks by
companies. Buybacks are essentially tax-free dividends to non-selling shareholders.7
The other choice is the use of the Earnings Per Share (EPS) of the company as a measure of its
return. This has the advantage of being readily determinable. It is true that if the company is not
paying a dividend, you do not have the current “return” in your pocket. But also you have not
paid taxes on the dividend and you do not have to find another place to invest it. So if the
company is reinvesting your money for you by not paying it out as a dividend, then they are
reinvesting your money tax-free. Do you trust them to do a wise thing with your portion of the
company’s earnings? If you do not trust the company management, you certainly should not be
invested in it!! Current Earnings Per Share is selected as the measure of our current returns.
So we are going to change the focus of our investment portfolio from a measure of the current
value of the underlying stocks to a measure which focuses on the income generated by these
shares. Now we will operationalize our approach using current eps as a surrogate for current
return. We selected the first 10 companies, alphabetically, from the S&P 500.8
7
Symbol
Current
Price
Three M
MMM
144.83
Abbott Laboratories
ABT
42.73
Abercrombie & Fitch
ANF
40.42
ACE
ACE
104.08
Adobe Systems
ADBE
72.55
Advanced Micro Devices
AMD
3.83
AES
AES
15.109
Aetna
AET
84.64
AFLAC
AFL
63.71
Agilent Technologies
A
56.15
Their share of the company is proportionally increased when a company repurchases shares. This is the same as
if they received a dividend and immediately used it to purchase more shares in the company. The advantage of the
company buying the shares itself is that it is using pre-tax money to buy the shares. If you received a dividend, you
would likely have to pay tax on that dividend before you could invest the remainder in the company’s shares. See
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1051281
8 The selection was limited to companies which had current earnings. This eliminated Affiliated Computer System. It
was assumed that any screening system which focused on current earnings would eliminate companies which did
not have current earnings.
4
Next we took the estimated Earnings Per Share from the projections of Yahoo Finance. The
estimates, as reported on Yahoo finance, are used only for illustrative purposes. Other sources,
such as Starmine9 or the projections reported by brokerage houses, would allow one to tweak the
estimates.10 The earnings estimates for our ten stocks are:
Symbol
Current
Price
EPS
Current
Year
EPS
Next
Year
Three M
MMM
144.83
7.47
8.22
Abbott Laboratories
ABT
42.73
2.23
2.47
Abercrombie & Fitch
ANF
40.42
2.36
2.8
ACE
ACE
104.08
8.88
9.25
Adobe Systems
ADBE
72.55
1.23
2.09
Advanced Micro Devices
AMD
3.83
0.19
0.17
AES
AES
15.109
1.33
1.44
Aetna
AET
84.64
6.54
7.18
AFLAC
AFL
63.71
6.25
6.55
Agilent Technologies
A
56.15
3.07
3.41
Next, a $100,000 portfolio with $10,000 in each of the securities is assumed.11
9
EPS
Next
Year
Share
purchased
for
$10,000
Symbol
Current
Price
EPS
Current
Year
Three M
MMM
$144.83
$7.47
$8.22
69.05
Abbott Laboratories
ABT
42.73
2.23
2.47
234.03
Abercrombie & Fitch
ANF
40.42
2.36
2.8
247.40
ACE
ACE
104.08
8.88
9.25
96.08
Adobe Systems
ADBE
72.55
1.23
2.09
137.84
Advanced Micro Devices
AMD
3.83
0.19
0.17
2,610.97
AES
AES
15.109
1.33
1.44
661.86
Aetna
AET
84.64
6.54
7.18
118.15
AFLAC
AFL
63.71
6.25
6.55
156.96
Agilent Technologies
A
56.15
3.07
3.41
178.09
http://www.starmine.com/index.phtml
For the most part all of these use the same sources. Starmine and others report the past efficiency of different
institutions in estimating these earnings. This allows the investor to put more emphasis on some projections and
less on others.
11 We allow for partial purchases of shares to make all the investments equal.
10
5
The earnings estimated for the current year for each company is next multiplied by the number of
shares purchased with $10,000.
EPS
Next
Year
Share
purchased
for
$10,000
Current
Earnings for
Shares
Owned
Symbol
Current
Price
EPS
Current
Year
Three M
MMM
$144.83
$7.47
$8.22
69.05
$10,000
$515.78
Abbott Laboratories
ABT
42.73
2.23
2.47
234.03
10,000
521.88
Abercrombie & Fitch
ANF
40.42
2.36
2.8
247.40
10,000
583.87
ACE
ACE
104.08
8.88
9.25
96.08
10,000
853.19
Adobe Systems
ADBE
72.55
1.23
2.09
137.84
10,000
169.54
Advanced Micro Devices
AMD
3.83
0.19
0.17
2,610.97
10,000
496.08
AES
AES
15.109
1.33
1.44
661.86
10,000
880.27
Aetna
AET
84.64
6.54
7.18
118.15
10,000
772.68
AFLAC
AFL
63.71
6.25
6.55
156.96
10,000
981.01
Agilent Technologies
A
56.15
3.07
3.41
178.09
Investment
10,000
546.75
$100,000
$ 6,321.05
EPS
Next
Year
#Shares
purchased
for
$10,000
Investment
Current
Earnings
for Shares
Owned
Symbol
Current
Price
EPS
Current
Year
Three M
MMM
$144.83
$7.47
$8.22
69.05
$10,000
$515.78
Abbott Laboratories
ABT
42.73
2.23
2.47
234.03
10,000
521.88
Abercrombie & Fitch
ANF
40.42
2.36
2.8
247.40
10,000
583.87
ACE
ACE
104.08
8.88
9.25
96.08
10,000
853.19
Adobe Systems
ADBE
72.55
1.23
2.09
137.84
10,000
169.54
Advanced Micro Devices
AMD
3.83
0.19
0.17
2,610.97
10,000
496.08
AES
AES
15.109
1.33
1.44
661.86
10,000
880.27
Aetna
AET
84.64
6.54
7.18
118.15
10,000
772.68
AFLAC
AFL
63.71
6.25
6.55
156.96
10,000
981.01
Agilent Technologies
A
56.15
3.07
3.41
178.09
10,000
546.75
$100,000
$6,321.05
6
As shown in the previous table, the investment of $100,000 ($10,000 in each stock) represents
annual earnings of $6,321.05. As these are only estimates, it is possible, indeed probable, that
the earnings will not be equal to the estimates. If one is careful in selecting the stocks to invest
in, it is likely that a greater number of the differences will be in the investors favor.
In order to complete our analysis we divide the annual earnings by 365, the number of days in the
year. The $100,000 investment is earning $17.32 per day. If one focuses on the earnings of the
investment, $17.32 per day as opposed to the investment principal, $100,000, then changes in
the price of the underlying securities only matters if such changes are the result of changes in the
estimated earnings of the company, or if one is contemplating selling the security. This might be
appropriate, for instance, if the price of the security has gotten too high, in the investors
estimation, in relation to the underlying earnings
Mutual funds present a unique challenge when using this new perspective. As stated earlier,
most mutual funds vastly underperform the general stock markets.12 However there are funds
that do beat the market and time constraints or other considerations might make these the wisest
investment for you.13
Mutual funds invest in many stocks.14 Assuming that you have chosen a mutual fund which
consistently beats the market, to include it in your return calculations, you need to know the P/E
ratio of the stocks it invests in. As an example, we will analyze the mutual fund, AMG Yacktman
Service (YACKX). If you go to Yahoo Finance and type in YACKX and then click on “Holdings”
on the left side, you will see the following:
12
Consider that if they equaled the returns of the S&P 500, their fees would cause the investor to receive less than if
he or she just invested in the S&P 500 themselves. There are other forces which contribute to mutual fund
underperformance. See “The Other 5%” at http://aspnet.cob.ohio.edu/isms/cobcontent.aspx?5688 .
13 Finding these is covered in “The Other 5%” at http://aspnet.cob.ohio.edu/isms/cobcontent.aspx?5688
14 Because we argue that stocks are a superior investment vehicle to other choices, we limit our discussion to mutual
funds which invest solely in stocks.
7
Note that the average Price Earnings Ratio of the stocks that YACKX holds is 17.06. Taking the
inverse of that gives the current yield at the current price, 5.86%. Now take that number times
the investment you have in the mutual fund, say $10,000 and you get $586 per year. Divide that
by 365 and you get $1.61 to add to your daily earnings total.
8
A major problem of this new way of looking at stocks can also be considered one of its strengths.
Emphasis on current earnings would tend to cause one to invest in stocks with a low price
earnings ratio. The stocks with the lower current price earnings ratio provide the highest current
earnings. Given that the intrinsic value of a share of stock is the product of current and future
earnings, stocks with higher current earnings as a percentage of current price are those with the
lower future earnings growth prospects.
As an example, consider two stocks. Stock A has a current yield (current year EPS divided by
current price) of 5%. Stock B has a current yield of 2%. If they are both selling at a price that
equals a 10% return to the investor, stock A assumes a 5% growth rate into perpetuity and stock
B has an 8% growth rate imbedded in its price.
Stocks with higher price earnings ratio imply a greater growth rate than those with low price
earnings ratios. In many cases this implied growth rate, when tested against stock valuation
models, is found to be unrealistic. When selecting stocks one cannot just focus on current
earnings but must also consider other factors such as growth rate, returns of other investment
opportunities and so forth. The approach advocated in this paper would tend to steer the investor
away from those securities with the lower current earnings when compared to the stock price.
This might not be such a bad thing. And, with some thorough research, it is possible to find
stocks with high current earnings when compared to current stock price, with acceptable
projected growth prospects. The relationship between the implied growth rate and the actual
growth rate is tenuous. So a higher P/E ratio, and its resultant lower current earnings as
compared to the stock price, does not necessary pay off in higher future earnings. 15
15(See
http://www.kc.frb.org/publicat/ECONREV/PDF/4q00shen.pdf.)