Wealth, Actually

by Frazer Rice

  Microsoft initially followed a path like Google’s, using their cash for product research and development. Over time, Microsoft discovered that its stock was a good investment for shareholders. The company started paying a dividend. Just because it started out with one model didn’t mean it had to stay that way forever. As the company matured, so did its strategy. A tech company doesn’t necessarily stay in high-growth mode forever. Depending on the type of investor you are, these variances might be appealing.

  Similarly, Chevron invests its earnings in looking for new oil fields and energy sources, but it also returns cash to its investors. This can be interesting to people who want to participate in the energy industry and want to have a stock that will increase in value over time while also providing cash flow in the short term.

  In general, a good business is one that generates cash. You can determine whether you’re a better user of the cash generated, either through your investments or spending, than the executives making the decisions around the cash. This goes back to the idea of how much you cost, whether you need current income, or whether your goal is to invest for the future.

  If you believe Google or Apple will continue to build unbelievable products that disrupt the world, it may be worthwhile to buy into that type of growth investment, if it aligns with your goals. If you require current income to fund your lifestyle, however, a long-term growth stock won’t be a good fit. It comes down to analyzing where stocks fit into your overall investment portfolio.

  There are scenarios where investing for growth makes sense. As we stated before, if assets do not need to generate current income and the assets are in taxable accounts, you may want to invest in companies that reinvest their profits internally. This can lead to an exceptional rate of growth.

  Snapchat is a good example of a high-growth situation where it’s unrealistic to expect the company to deliver cash flow and dividends to the shareholders. Snapchat is going to be spending as much of its money as it can internally to build and maintain a profit, make sure vendors are paid, compensate talented employees, and extend its platform to achieve scale on operations. Its goal is to take in more money than it spends, which, ultimately, is the hallmark of a good business.

  Someday in the future Snapchat may generate so much money—and its world may become mature enough—that its cash may be best used to pay back investors, rather than to invest further in growth and operations. I believe we’re a long way from that point, however. Beware if an innovator, especially a tech start-up, promises cash flow in the short term.

  International Risks and Benefits

  As we talked about in the last chapter, stocks are not limited to the United States. There are stock markets around the world, and companies based in other countries can also generate revenue for investors. Coca-Cola is an example of a company that generates revenue worldwide. It has a measure of international exposure that you would not see from a Midwestern insurance company that does business in only two states.

  Geography creates a different type of risk, as well as a different set of benefits. I tell clients that international stock can be part of a well-diversified portfolio. If the US economy tanks, other global economies may continue strong. Exposure to a broad array of asset classes and geographies will spread risk across multiple good investments. Additionally, many US companies derive their revenue from sales outside the United States, and those companies that can help you get international exposure and diversification.

  Final Risk: Stock Is Low on the (Capital) Totem Pole

  If something goes horribly wrong with a company, stock shareholders are far down the chain of people who are repaid their money. If a company goes bankrupt, the equity owners with a stock position in the company are going to lose first. Bondholders are normally paid first in the chain of creditors, if anyone is paid at all. If you’re investing in a stock that you view as high risk, you’re going to be the first one to lose if things go south.

  Bonds

  A bond is essentially a loan in exchange for a certain payment stream. A municipal bond is issued when a governmental entity—often a city, town, school, or utility—needs to raise money for a project. The bonds pay back the borrowed principal to investors in addition to interest. A corporate bond operates in the same way, but it involves a company. As an aside, there can be tax advantages to investing in municipal bonds, and because of this, the bonds tend to be popular with taxable individual investors.

  In the traditional bond market, a securitized bond faces the same hurdles that stocks do when it comes to providing comfort to the market of investors. Bond issuers are required to provide documentation to the government. The information is available to the public but usually requires an expert level of financial knowledge to understand. There is a well-developed infrastructure of agencies that analyze this information and rate the creditworthiness of the bonds, and financial advisors can also dive into the details a bit more for you.

  Risks Associated with Bonds

  There are many different risks with bonds, but the two biggest risks are duration and credit quality. Duration risk occurs because of the length of time between investment and repayment to the investor. During that time—which could span from months to years—will the interest rate being earned hold up over time? If market interest rates rise to 4 percent and the bonds are paying 2 percent, their value isn’t going to hold up. There are better investments out there.

  It can be tricky to sell a bond before maturity. Bonds are not as liquid as stocks. It may be difficult to find a buyer for a small volume of bonds or to trade bonds that are not round numbers. The interest rate is also a factor. If you have a bond with a 2 percent interest rate, but current interest rates are at 4 percent, it will be a challenge to find a buyer. You may have to split up your bond position, which creates liquidity issues.

  The bond market is highly fractured with many different issuances, which also affects liquidity. This differs from the uniformity of the stock market, where there are a lot of buyers and sellers. That said, with bonds you are still dealing with well-understood streams of revenue. Assuming those streams of revenue are stable and reliable, you should be able to find buyers.

  With respect to credit quality, US government bonds are the safest, followed by state bonds and city or municipality bonds. In most cases, with their relatively low-risk levels, it’s taken for granted that the promise to repay will be honored. With corporate bonds, however, the likelihood of repayment is a calculation you should make when deciding whether to invest. You will have looked at a company’s balance sheet and its capacity to have cash on hand to make those payments over time. If you’re confident the company can maintain the income stream being promised to the investor, then the credit quality of its corporate bonds is probably good.

  A professionally managed bond portfolio will address duration risk and credit quality. In the case of municipal and corporate bonds, bondholders are usually paid first if something blows up, making them “safer” than stocks for the traditional investor. Although bonds are less liquid than stocks, the transparency of bonds is generally better. You just need the ability or guidance to analyze the information generated in a bond issue. That may exceed the scope of most people’s patience, but the rating agencies provide shorthand information on that front.

  The yield of a bond is established up front, and the terms of repayment are consistent unless the bond goes into default. If you hold a bond to its maturity, you should get the money you put in, plus interest at the stated interest rate. If you sell the bond before it matures, you sell it at the price that the market will bear. That value can be determined by a number of factors, including perceived credit quality and the current interest rate environment. The quantum of safety is better than stocks but not as safe as cash. You’re dealing with the full faith and credit of the institution that you’re lending money to.

  Because they generate predictable income streams, bonds often
form the bedrock of many investors’ portfolios. They are a good starting point for building out a portfolio to serve investors who need current income streams.

  Alternative Asset Classes

  Once portfolios are positioned to generate the income needed, some investors may be willing to expand beyond stocks and bonds into alternative asset classes such as private equity funds, hedge funds, commodities, or real estate. This is a way to enhance their investment returns.

  Some people take the approach that if 90 percent of their assets provide dependable cash flow and offer the promise of future growth, then they’re willing to gamble a bit on more speculative investments with the remaining 10 percent of their portfolio. These are asset classes you won’t participate in with Schwab, Fidelity, and other traditional brokerage firms or money managers. These asset classes are more likely to be private deals with more customization, and as a result, they require much closer scrutiny and analysis.

  When dealing in alternative investment classes, you will need a trustworthy advisor. If you’ve found someone honest who doesn’t push a particular product down your throat, you’re likely on the right track. However, be suspicious of someone who makes a presentation or recommendation without taking the time to really understand your needs.

  It’s important for the advisor to be a good fit for the client. I’ve run into situations where a client has views and opinions that run counter to the advice I’d give. In those cases, I feel it’s okay for the advisor to walk away from the business. There are plenty of other advisors who will do anything the client wants, even to the client’s own detriment. That’s not how a good advisor forges long-term relationships or builds a good business.

  With people who wish to invest in asset classes beyond stocks and bonds, I explain what alternatives exist and learn if clients have had any experiences with those asset classes. We’ll talk about the functions of alternative investments, what purpose they serve, and whether they will meet this client’s needs. We write it all down and revisit it when we review their investment plan on a quarterly or annual basis. This helps the client understand the function of these investments and ensures the investments continue to be in alignment with the client’s goals and objectives.

  Private Equity and Venture Capital

  Private equity investments work like stock investments, with the exception that private equity funds are not required to register publicly with the SEC. Registered, publicly traded stocks have required quarterly calls and information-sharing procedures, but private equity funds do not. Therefore, there is less transparency and fewer sources of information. Investors must be qualified by income or asset level to participate.

  The primary focus of a private equity investment tends to be a family-owned or closely held business that generates cash flow and could later be sold for a profit. Operations within this type of business are transparent to the owner but not necessarily transparent to the public. This can lead to a situation where there are three different types of books and reporting: the books you show investors, the books you show the IRS, and the real books. This can exist in the world of small private businesses, and it’s not necessarily illegal. There are often several ways that different types of information can be presented.

  Private equity typically offers less liquidity than public stocks, as the sale of private equity businesses or interests is a customized procedure that can take months or years to complete. There’s a smaller pool of buyers and sellers, which contributes to the illiquidity. For a publicly traded stock such as Coca-Cola, there may be hundreds or thousands of buyers, but for a family-owned business, there may be only one or two interested buyers. Even if there is a willing buyer and willing seller, the two may not be in alignment. Even if a purchase price is agreed upon, the due diligence process of the transaction often requires a long time to complete.

  If a single person owns the entire business, the selling side of the transaction is less complicated. Even with multiple owners, it’s relatively easy, assuming one person owns a majority of the shares and has a controlling interest in the business. Selling can get complicated, however, when there are multiple owners and no majority owner or controlling interest. If each owner must approve the transaction, complications can quickly arise. The investment becomes less liquid when selling is difficult.

  When it comes to yield, the business owners or executive management will normally have a good sense of how much cash flow should be distributed to investors and how much should be reinvested in the company toward growing its value. In many cases, the goal is to build the business and its profitability by reinvesting profits, but on the yield front, they may choose to pull out money for current income or the diversification of their investment portfolio. Business owners either focus on current yield or long-term growth, and those factors can change over time.

  Private equity businesses can be owned in a fund environment, with pooled investments from multiple investors. They can buy a company to make changes that create value or invest in a portion of a company for longer-term growth. When buying the entire company, the investment may take the form of a leveraged buyout fund, where borrowed money is added to the investors’ money to achieve more scale. In this scenario, liquidity is usually low, because the pools of money tend to be locked up for long periods. These are investors with management experience who buy companies with the intent to improve them and create value going forward. They need the invested money to work over a longer time horizon and can’t have a situation where the invested funds are being pulled in and pulled out.

  In terms of yield, you may have a bit of yield from the fund because your coinvestors will want to see a return on their investment. It’s hard to imagine investors giving their money to somebody with no expectation of a return of capital for ten or twelve years until the fund ends. Most people want to see something happening over time, and if a fund is invested in different companies, those timelines aren’t going to be aligned. You may have somebody who turns around a company and sells it within three years, delivering a good return to the shareholders. Or you may have a turnaround that takes twelve years. If the fund has a diversified portfolio, some of those turnarounds are going to be more effective than others. What ends up happening over time is the yield will look to investors like infrequent blobby distributions that are difficult to predict.

  For businesses owned in the fund environment, private equity is not the only option. There is also venture capital. Venture capital-backed companies are typically new and developing companies that will invest their raised money and profits back into their company. Liquidity is often lower than in a private equity business buyout, because every dollar of the venture capital-backed company will likely go back into growing the company.

  Transparency is also low. You’re relying on the fund to provide information about the general direction the company is heading, and there may be a time lag before that information reaches you. Additionally, the reports and numbers you receive are not vetted by any government agency. Management strategies can shift. By and large, this is a speculative situation when it comes to the timing of your investment and the company’s ability to grow to great profitability.

  Current income and yield in these venture capital funds are often low or nonexistent. The dollars raised are focused on growing the company and its technologies, taking the enterprise to scale, and improving sales as quickly and widely as possible. The payoff of an investment like this (if there is a payoff) normally occurs in the long term via a balloon payment, acquisition, or initial public offering.

  With both private equity and venture capital investments, participation normally happens by buying a limited partnership (LP) interest in the endeavor. With this structure, you usually have a general partner managing the investments and the direction of the fund. The general partner has control over the fund and is part of the investments that the fund holds. The LP interest provides a qualified investor with an equity i
nterest in the assets of the fund. If there’s a one-hundred-million-dollar fund with ten equal LP interests, each investor has a ten-million-dollar interest.

  Risks of Private Equity and Venture Capital

  The main risks of private equity and venture investments are the loss of your investment and the time your money is locked up within the investment.

  A good private equity manager may have done a solid job creating value for a company, but a great manager has an exit strategy—they have a plan for selling the company or taking it public to receive profits in the form of cash or equity positions in other companies. Without a good exit strategy, you could be an owner in a company but not benefit from its success.

  In the private equity world, if there is no clear exit strategy up front, you hope to have a yield component and receive dividends from the cash flow generated by the business or fund. However, there are no guarantees, and you are at the mercy of general partners and what they do with the fund.

  The risk is even greater with venture capital, where you’re dealing with investments that are much more speculative and growth-oriented. If ten investments are being funded, there is usually the expectation that one will really hit big, two or three will do okay or break even, and the rest will fail. You hope that one investment succeeds in a powerful way to justify both tying up your money and taking a risk. If you need the money before you reach the terms of your commitment, it can be complicated and expensive to extricate yourself. If the partners allow it, you’ll have to find an investor to take your place. There is a secondary market for people to buy LP interests that others need to divest, but it’s usually an expensive process.