In a labor–management situation, for instance, a company may want to partner with its union to improve quality, productivity, or processes—yet it wants to be adversarial when it comes to negotiating benefits and wages. These two contrary positions may be difficult to understand. A true partnership needs to focus on mutual interests, but it doesn’t have to encompass all the interests of both parties. Even in a labor–management dispute over compensation, the two sides can succeed in forging a partnership based on common objectives to resolve their dilemma.
After the partners have determined the scope of the partnership, they must communicate quickly and often to make sure both sides understand the limits of the partnership. My friend Larry works for an airline that recently offered its employees stock in the airline in exchange for pay cuts. The company broadcast its offer through the media—emphasizing the opportunity for employees to own the airline, just as management does with its stock ownership program. But Larry discovered he did not have the same benefits and privileges the managers had; while managers fly for free, the union employees pay a nominal fee for their passes. Larry resents the fact that while he takes stock instead of dollars, just like management, he doesn’t enjoy the same treatment. The managers’ free seats undermine the credibility of the public relations campaign aimed at building employee morale.
Aggregate financial ratios give a reliable picture of the state of the highyield market and should not be neglected irrespective of technical factors. Technical factors driving the high-yield market can change fairly quickly but credit status will persist as hard evidence and change only slowly over time. The most important fundamental measures are:
- Free cash flow generation
- Refinancing calendar
- Access to capital markets (bank lending standards)
- Reported earnings and earnings outlook
- Equity performance
- Growth prospects
- CAPEX needs
- Leverage trend
- Coverage trend.
Leverage and coverage ratios are particularly important for the analysis of high-yield issuers. We find significant correlations between the spread levels of selected high-yield issuers and their coverage ratios and their leverage ratios.
Fund flows measure the amount of money that comes into or leaves the open-ended mutual funds during a given period. Coupon payments are not included. The flows of pension funds, hedge funds and insurance companies are not tracked in this number. Nevertheless, there is a high correlation between high-yield market total returns and mutual fund flows. The reason is that mutual funds account for a big part of secondary trading.
During a period of high market uncertainty and increasing negative event risks the correlation with equity markets tends to rise. Fund flows in the high-yield market are directly related to the developments in the equity market.
Fund Flows are a function of:
- Expected risk
- Interest rates
- Inflation
- Default rates
- Economic outlook
- Event risk
Index fund investors and pseudo-index fund investors must be prepared for a decade of mediocre returns. Stock investors looking for the fast lane will find it clogged. Frustration and other symptoms of unmanageability will be common. Should indexing lose popularity, returns will turn negative as investors seek alternatives. If the herd abandons the index funds for money market funds, bonds, real estate, or other asset classes, all the emotions of a panic can be expected. If you are an independent thinker, you are best off avoiding mutual funds.
Long-term mutual fund holders often drift into indifference. After a few years, they have no sense of connection with their money. All fund statements and mailings are glanced at and filed or thrown out. In the back of their minds, they know there is something they ought to be doing but having put it off for many years, they simply leave it be. Mutual funds in IRAs and 401(k)s are often abandoned for decades. On retirement, the holders are shocked at how little money has accumulated.
Active investors become resentful of fund managers. Fund managers’ salaries are insulated from fund results. Salaries rise in bad years as well as good. With no stake in the outcome of their investment decisions, fund managers’ interest and yours are opposed. Fund managers make more Money than doctors, lawyers, and all but the CEOs of the largest corporations. Yet their results are no better than random picks from the stock tables.
Most managers pick stocks by the numbers: P/E ratios, earning growth rate, EBITDA to enterprise value, and so on. Hundreds of studies have shown that you cannot outperform the market looking solely at numbers. Insight is required. But insight can cost a manager his job and a $500,000 annual salary. Picking stocks by the numbers as does everyone else, keeps those paychecks rolling in. In interviews and slick marketing brochures, mutual fund managers boast that they have one-on-one contact with company managers. Unfortunately for you, every mutual fund manager talks to the same company managers at your expense. Trips to New York, Boston, Silicon Valley, and Los Angeles are paid for by you. Investment conferences in Las Vegas, Honolulu, and Hong Kong cost you even more money. Because all the fund families talk to all the companies and go to all the conferences, no one gains any insight and all return home to the same numbers.
Fund gathering, job security, and indexing has resulted in most funds, index and non-index, owning the same stocks. Overowned stocks have huge market capitalization. It requires larger and larger purchases of stock to move prices up. In essence, $100 million in new money will increase the value of a $1 billion stock by 10 percent; a $100 billion stock will only increase in value by 0.1 percent.
For investors tired of watching mutual fund managers make lousy decisions and underperform the market, mutual fund families invented the index fund. The manager of the index fund buys and holds the stocks in the market index. Index funds return exactly what the market returns. Index funds have become extremely popular in the last decade.
As index funds increase in popularity, many non-index funds also imitate the indexes. Increasingly, more and more funds buy the same stocks, have exorbitant marketing expenses, and have the same goal: increasing funds under management. Stock selection is motivated by this goal. A fund full of unknown stocks will not be recommended by financial planners or understood by the public. Unusual funds are quickly labeled “too risky” and disappear.
Mutual fund families comb through the stock picks of each fund and assure that a minimum number of the popular index stocks are present. Managers who vary too far are reprimanded and eventually fired if they do not conform.
Each investment has its own emotional traps. Ancient tribes stored seeds through winter. These tribal savings were loaded with community and individual feelings. Today, few realize the embedded emotion in passbook savings accounts until banks begin to fail or inflation destroys the purchasing power of precious dollars.
Investing produces a wide range of emotion. The highs can be as disorienting as the lows. The most common emotional traps are described here. For each, consider if you would be comfortable owning investments that produce these feelings.
By getting your debts taken care of as soon as possible, you can begin taking care of this goal, so that it, too, doesn’t overwhelm you later. After all, your goal is not to just eliminate debt or save for the future, but to do what you need to do, so you can get on with enjoying today.
Just like with retirement, there are things you should be doing today, even in the midst of getting out debt, to help prepare for future college costs:
Move to a different state. Just kidding. But there are some states that offer their residents a matching contribution for putting money into a Section 529 plan. For example, the Arkansas Aspiring Scholars program will match a $250 contribution to their state savings plan with up to $500 (depending on income).
Check with your state treasurer’s office to see if such a plan exists. Contribute toward college for holiday and birthday gifts. Consider opening college accounts for your kids at your local brokerage house and asking the grandparents to divert some of their holiday spending there. Trust me, your kids will appreciate it way more than a pair of socks.
Use UPromise and BabyMint. Both of these services are free to sign up for, and set aside money into a college account for your child every time you shop. It doesn’t actually increase the cost of your purchases, but instead is a way for stores to reward you for your loyalty. You can also have your friends and family register their cards to contribute to your child as well.
I’m not going to bore you with every possible financial goal, but if you plan on putting yourself or someone else through college in the future, it’s imperative that you begin to save for that now. Again, to save adequately, you’ll need to eliminate your monthly debt obligations as soon as possible.
Failure to plan for college expenses has two major effects in my experience. First, many people who have not planned and saved adequately usually stop saving for their other goals while scraping to pay for tuition. Even a small delay in getting started on saving can have a huge impact on what you’ll have to save later to play catch-up. Second, the failure to plan for college usually results in the accumulation of more debt in the form of student loans. While these are often a necessary evil, they can be one more financial weight around your already exhausted neck. (See Chapter 15 for more on student loans.)
The magic by which seemingly small income streams get magnified into huge market valuations is intimately tied up with the arcane mathematics of perpetuities. It sounds dull, but it is well worth understanding because it is the mathematical foundation of Wall Street wealth.
Aperpetuity is defined as an investment offering a level stream of cash flows forever. What is the value of a perpetuity paying $100 per year forever? Using a cost of capital of 12 percent, it would be the present value of the first payment, plus the second payment, plus the third payment, . . . , plus the fiftieth payment, and so on; that is, $89.29 + $79.72 + $71.18 . . . . The value of the payments gets progressively smaller. The value of the fiftieth payment is only 3 cents!
It turns out that the present value of this stream, no matter how far one goes out in time, cannot exceed $833.33. That number is the free cash flow of $100 divided by the cost of capital, 12 percent, or 0.12—a very simple relationship that we introduced earlier.
Mathematicians say simply that this series converges to a finite limit. This one converges fairly quickly—it reaches 90 percent of the limit in 20 years, and 95 percent in 26 years. So in a practical sense, realizing the value of a perpetuity does not take forever, just a period of time that is consistent with the lifetime of a durable business.