The Rules, Part LII

ge + E/P > ilongest bond

Let me explain.  The first term is the growth rate of earnings for a company.  The second term is the earnings yield of a company.  The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.  Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.  If it does not work, consider buying the bonds and/or selling the stock.  On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.  Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases  in earnings?  No, that’s not likely, they might even issue more shares in such a situation.  Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.  Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.  What should he do?  I looked at the bonds of the stocks and saw that they were trading above par.  He thought they were going bankrupt, but the bond market did not agree.  I told him to cover.  He objected, but I said, do you want to cover at a higher level?  Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).  They may give you valuable data that the stock market does not know.