Preferences
“There are many paths to the top of a mountain.” – Chinese Proverb
As a younger individual, I never really grasped the profound meaning behind that simple saying. In a discussion, I would pick a side and pound the table, trying to illustrate how “my way or my belief” was right. As I have grown older, I have come to appreciate uncertainty, respect that those who disagree could be right, and understand how nuanced situations can be. Several routes can lead to a similar endpoint. Take the current CEO of Microsoft, the founder of Ford, or the originator of Kentucky Fried Chicken. All went on to find success in business, but each took a vastly different path.
Satya Nadella, CEO of Microsoft, had a strong technical and business education when starting at Microsoft and worked his way through the ranks to become the CEO. Henry Ford transformed the automobile industry through apprenticeships and real-world experience rather than a formal university degree. (He never even went to high school.) Colonel Harland Sanders, founder of KFC, did not find success until his later years in life after a long string of failed ventures. Each of these individuals led thriving businesses, yet the avenue by which they got to the end goal differed greatly.
The same can be said when it comes to investments. Investors are provided with several different asset classes where they can choose to allocate funds. There is no objectively right answer to which asset class reigns supreme as they each serve different purposes and have distinct advantages. We at Monarch do have a preference, which we will explore in more detail through this newsletter.
A few recognizable asset classes include: equities (stocks), fixed income (bonds), and alternatives (three we will discuss are real estate, precious metals, and private equity). A short description of each is provided below.
Equities (Stocks):
Stock represents a share of ownership in a company. When an individual buys stock, he or she becomes a part-owner, or shareholder, and is entitled to a fraction of that company’s earnings. Shareholders typically make money through share appreciation, when the price of a stock increases and/or through dividends, when a company decides to distribute a portion of its earnings to investors through a cash payment.
Fixed Income (bonds):
Bonds represent a loan with the promise to repay any borrowed money, along with a set amount of interest. A bond works similarly to a loan, with the investor acting as the lender and the issuer acting as the borrower. In exchange for a loan today, the lender agrees to pay the borrower back in the future, in addition to making interest payments. (There are bonds that don’t pay periodic interest, known as zero-coupon bonds, but these are typically bought by investors at a deep discount to the fixed amount the issuer promises to pay back to the bondholder when the bond matures, with the difference representing the accrued interest earned over time.)
Bondholders are creditors and are given legal priority over other stakeholders in the event of bankruptcy. Stated differently, bondholders would be made whole before equity holders if a company was forced to sell its assets. Although nuanced, bonds are generally considered “safer” than stocks by the majority of the financial world due to typically having lower volatility, providing fixed income (interest payments), and having a higher claim on assets if the company goes bankrupt.
Real Estate:
Real estate investing is buying property (buildings, land) to generate profit through appreciation, rental income, or sale. This can be done by directly buying physical property or by purchasing a real estate investment trust (REIT). A REIT is a company that owns and operates income-producing real estate, allowing individuals to invest in properties without buying or managing them directly. Most REITs operate in a straightforward business model: by leasing space and collecting rent on the real estate, the company generates income that is then paid out to shareholders in the form of dividends. REITs can avoid corporate income taxes, but they are required to pay out at least 90% of their taxable income to shareholders to do this.
Precious Metals:
Precious metals investing involves buying assets like gold or silver usually to hedge against inflation and protect wealth during economic uncertainty and/or diversify investment portfolios with assets that are less correlated to the stock and bond markets. Investors can buy the physical metals or purchase an exchange-traded fund (ETF) that provides exposure to these metals either by holding the physical metal or investing in mining stocks.
Private Equity (PE):
Private Equity is equity or equity-like investments made into private companies or assets (not publicly traded or listed on a stock exchange). Private equity firms customarily raise money from investors to acquire and manage companies, with the goal of improving them before selling them for a profit.
There are many different operating models for PE firms depending on the firm itself, the timing of their fund, and the assets they are managing. Some want to buy distressed assets, cut them to the bone, prop up the financials, and then flip them. Others act more like venture capitalists where they are in it for a longer period of time (5-7 years), but again, it depends on the timing of the investment and the timing of their fund’s maturity.
An analogy often used compares that of a homeowner to a home flipper – a homeowner has an interest in making the house a nice place to live for themselves, so they may invest in nicer, more durable flooring, appliances, and countertops. Every decision they make answers the question, “Will this make my home more livable for me and my family long term?” The flipper is concerned with making a profit off the house, so he or she will make the decision based on the calculated ROI.
Some private equity funds have been extremely successful and have gone on to produce significantly outsized returns for investors, this is especially true over the past two decades as private equity has outpaced public equity markets. An advantage of PE is that it has a larger pool of companies available for investment compared to public markets. However, there are added risks as well. PE is often illiquid, has higher fees, and less transparency. Statistically, there is also an increased risk of failure with private equity ownership. According to a 2019 study, researchers at California Polytechnic State University found that PE portfolio companies are about 10 times as likely to go bankrupt as non-PE-owned companies. In addition, until the companies owned by a private equity fund are actually sold or taken public, the firm’s returns are only estimates of how their companies should be valued. Public markets use daily mark-to-market accounting based on active trading prices, while private markets use appraisal-based valuations updated quarterly or less frequently.
We want to clarify that the purpose for describing each asset class above is not to suggest that one is “better” than another as they each can serve different purposes. Historically, stocks have outperformed bonds and gold over the long term. While gold generally acts as a hedge against inflation and bonds provide stability, stocks have offered higher wealth accumulation. The following logarithmic chart shows the returns (after adjusting for inflation) of some asset classes over more than 200 years.
Look at the performance of the dollar. The chart illustrates the importance of investing. A dollar is worth much less today than it was 200 years ago and that primarily is due to inflation. Stocks historically have performed the best. Does this mean that stocks will continue to outperform moving forward? Not by any means. Any asset class can outperform over short time frames, and the future is never certain. However, there is a unique benefit of equity investment that gives it an advantage over other asset classes. Equities can compound in value in a way that investments in other asset classes such as bonds, precious metals, and real estate, cannot. Why? Companies can retain a portion of the profits they generate to reinvest in the business. If you look at a major index such as the S&P 500, you will find that on average, companies pay out about half their earnings in dividends. The earnings that are not paid out are invested back into the business. This is not something you typically see in other asset classes. If you own bonds, you receive an interest payment, but this is not automatically reinvested in the bonds. Similarly, if you own real estate, you will receive rental income, but it won’t be reinvested in property for you. Precious metals do not pay interest or dividends as they are a non-productive asset (do not generate income or cash flow on their own).
This unique feature of equity can also be a valuable source of compounding. For example, if you owned the average company in the S&P 500 index last year, it earned a return on equity of roughly 12%. If that company can retain half the earnings that are attributable to an investor and it can continue to invest at its current rate of return as the business grows, that half should also earn 12%, thereby displaying this compounding effect. What makes this even more attractive is that, on average, the companies in the S&P 500 currently trade at three times book value, so for every dollar of earnings they retain, it currently creates $3 of market value. Granted, this of course – the valuation given by the market – can change.
The above illustration shows the benefit of equity investment in financial terms. Nonetheless, the company must have a source of growth to enable it to reinvest retained earnings and importantly, the growth must come at good rates of return. History is littered with examples of companies that start with good rates of return but then invest retained earnings at much lower rates and ultimately destroy instead of create value for shareholders.
Keep this information in mind when you hear debates about what the best asset class is. The truth is, there is no single “best” asset class for everyone as the ideal investment depends entirely on an individual’s financial goals, risk tolerance, and time horizon. These are all considerations we take into account when constructing your investment portfolio.
From all of us here at Monarch, have a Happy New Year!
-Written by Adam Beard
