Investing in the stock market makes sense, part 2

Part 2 in a series.

So the first reason why investing in the stock market makes sense is that businesses, in the aggregate, ought to keep pace with the growth in Gross Domestic Product.

There are many ways as an investor to capture the growth in wealth generated by businesses; for example: stocks, preferred stocks, bonds, warrants and options. But let’s just talk about bonds and stocks.

Bonds

When we provide capital to a business and we don’t want to be owners of the business, we buy a company’s bonds. Bonds most typically pay a fixed interest rate to their buyers and promise to pay back the principal amount of the investment at maturity. Paying interest to bondholders is not elective, but mandatory. Bonds also have the advantage that they are higher up in the capital structure of a business. What this means is that if the business goes bankrupt then bondholders have priority rights to the company’s assets.

Because of the stable nature of bonds (interest paid, principal repayment, and asset dissolution priority) they are safer than stocks. Therefore, they usually pay lower rates of return than do stocks as well. Another reason that bonds pay lower rates of return than stocks is that they do not directly capture the benefits of growth in a business. If a business grows it usually become more creditworthy, so there is the possibility of a credit rating upgrade and an appreciation in the value of the bond, but this is atypical.

This line of thinking naturally suggests the investment appropriateness of bonds. That is, bonds should only be issued to raise capital by companies that have low growth prospects, but that generate a slow and steady amount of income. For example, an electric utility company is a low growth business but one that has very secure and stable income. After all, most people do pay their electricity bills no matter what. So if a utility has a new investment project, like plant maintenance, or new power lines, it behooves them to issue bonds, not stock. This is because stock investors require a higher rate of return than that provided by bonds, thus stock investors desire higher growth. Does this make sense?

Stocks

Buying stock in a business means that you become a partial owner in the business. The advantage to being an owner is that you get to participate in the growth of profits of the business. This comes in various forms, such as capital appreciation, stock buybacks and dividends. If a publicly traded company does well investors typically demand more of the company’s stock which causes the prices to rise – this is capital appreciation. Some businesses pay out their profits in the form of dividends. However, when shareholders receive dividends they have to pay income taxes on these monies. So generally dividends are seen as tax inefficient. Why? Because the monies you receive as dividends have already been taxed at the business level. It is with after-tax profits that businesses pay out dividends. Consequently, many businesses elect to use their profits to buyback stock that is in the marketplace. By reducing the size of the ownership pie, the profits per share increase. Does this make sense?

The above discussion naturally suggests that certain businesses should issue stock. Namely high growth businesses where revenues, and thus income, are uncertain. If high growth, but low profit, businesses issue bonds then they are required to pay interest even in volatile profit times. Not only that, but high growth businesses want to retain their profits to reinvest back into the business. Thus, they cannot afford to pay interest or dividends. Unfortunately there are many low growth businesses that continue to have outstanding stock. What do you call the stock of a flat-growth business? A bond. I am suggesting that very low-growth businesses should be taken private by their ownership.

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The implication of the above discussion is that capital in the form of stock should be used only by moderate to high growth businesses. Generally this is actually how it works. Most publicly traded companies grow their earnings much faster than the growth rates in GDP. Roughly speaking the average growth in earnings for publicly traded firms is between 8-15%. Clearly this is much higher than the 5% growth in GDP. So axiom 2 for why investing in the stock market is…
Axiom 2: Stocks, on average, grow their profits at a much faster pace than GDP.

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Part 3 will be posted tomorrow.

Jason