My thoughts on risk premiums and how I invest:
>And recently there is debate over whether there even should be an equity premium. Certainly over the long haul, equities as a class truly haven't
been riskier than other asset classes.<
I have a few thoughts about why there are risk premiums and will probably continue to be so. I am going to use a future real world example from my life (I hope).
I love to play billiards. I would love to own a room someday where I can watch CNBC, watch racing from Saratoga, play nineball and drink McAndrews Scotch Ale. Nice life!
Let's say it will cost me 200 thousand to do so. Clearly, I will want a return on that 200 that compensates me for the risk of this investment. I will not accept a rate of return that is equal to either Coca Cola (6.5%) bonds or treasuries (5.6%). There is certainly a very real possibility of failure here. That is my required risk premium. It would need returns above these for sure. Probably significantly higher in this case. In real business that is exactly what is happening. Retained earnings are yours. I repeat this point. They are yours! They can be distributed or you can reinvest them for example in a new GM Saturn plant, or a new IBM software development, a new Tootsie Roll factory, or a Sbarro meat ball place. (Ummmmm!) In any case, the risk premium you will require to make the investments will be related to the risks of failure in each individual case. From very low in the case of Tootsie Roll to higher in the case of IBM. As a passive stockholder you are allowing management to make those judgements. So the rate of return you should require on your stock is related to the investments that are being made with retained earnings (WHICH IS YOUR MONEY) and the skill of management among other things.
It thus becomes difficult for me to see a scenario in which there is no risk premium for stocks. Especially since one already exists for high quality shorter term bonds and the there are REAL risks in business.
You could also not use your money and borrow instead. The cost of borrowing will be above the cost of governemt debt. For many businesses very significantly. In order to profit, you must therefore earn a return greater than the cost of borrowing. This cost will be much greater than governments in most cases. So again the business will be discounted to return higher than this cost of borrowing. Thus there is a risk premium relative to treasuries.
When viewed across the entire spectrum of the cost of borrowing (which includes some really risky stuff in corporate America) or using one's own money, it can become clear why there must be an AVERGAE risk premium of more than just a token 1% or a little more. It is up to the investor to judge what is appropriate for each business. From the lowest risk like Coca Cola to the highest risk like high-tech and bio-tech.
There is also a variance of risk under different economic conditions.
Different risks exist at different levels of inflation or potential deflation. There has been an enormous amount of study done on this which is available. I have reviewed much of it and it gives me a headache because the professors can't agree on many of the measurements. I believe there is significant value in reading and understanding it though.
Lastly, there have been periods of time where bonds may have been ridiculously priced and this accounts for high risk premiums for stocks. The 50's saw a period when bonds were basically certificates of confiscation. The very high risk premium that then existed between the asset classes was not so much that stocks were mispriced, but that BOND YIELDS WERE TOO LOW. Stocks were low for sure, but decently priced on a real return basis. Compared to bonds they were an absolute gift. Again it wasn't stocks so much mispriced as it was bonds in this case. This is a key point. Stocks were cheap but not as cheap as the comparison to bonds makes them appear. It was bond buyers who may have been nuts. Stocks were just a bit of a bargain.
There have also been numerous studies on this subject that suggest that stocks follow real rates of return (inflation expectations) more closely than bond yields. My own research indicates this, the federal reserve research indicates this, and even Abby Cohen says this (we agree wow). That long term real rate of return is approximately 7%. It varies slightly over time because of the interaction between inflation and taxes on the real after tax rate of return. (inflation is taxed so you need a higher rate in some periods and visa versa). My best guess for the real after tax rate that is average is about 4% +/- .5%. But don't quote me on this. That is just what I use in some of my value modeling and what my research indicates. Current inflation expectations for the next 10 years are about 1.6%. Do the math.
Margin of Safety, bargains or a good value could then be described as an after tax real rate of return that is HIGHER than the APPROPRIATE one as determined by the investor. Appropriate meaning including the risk premium.
Here are couple of other thoughts. Stocks as a group have not been more risky relative to other investments. That is only true if measured on an actively managed basis. S&P and Dow Jones are constantly substituting less favorable businesses with better ones. Thus the favorable returns. There was a wonderful study done by Stephen Leuthold a few years back. He tracked a bunch of industry leaders over the decades. You would be shocked how many faded or disappeared over time. So if you bought a portfolio and just sat on it, your returns would be nowhere near the active portfolio returns that we see from the S&P or the nifty fifty.
The problem is that in the real world, businesses are usually bought 100% and are not easily discarded the way they are in an S&P portfolio without cost. If you want to rid yourself of it by selling, someone else has it so in aggregate somebody is still getting bad returns. If you liquidate it, there are lawyers fees, golden parachutes, severance pay etc... These amounts can run into the billions as we know from the 90's.
These potential costs must somehow be part of the pricing and value structure of business in the real world even though they are not in the S&P500 etc.. Thus business people will insist on a rate of return that is high enough to compensate. This is a risk premium also.
In summary I think there have always been risk premiums and there will continue to be risk premiums. The one area of changing risk premiums that I believe is most important is that which is related to greed and fear. When people are greedy, exuberant, and times are good, risk premiums shrink. The opposite is true when times are bad and people are fearful. The true and appropriate rsik premium is unrelated to these emotions and you should try to exploit others changing moods.
Wayne Crimi
Value Investor Workshop
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