Newsletter June 15, 2013

InvestorsFriend Inc. Newsletter June 15, 2013

The First Rule of Finance, Courtesy of Aesop’s Fables:

“A Bird in the Hand is Worth Two in the Bush.”

In his annual letter for the year 2000 Warren Buffett explained that Aesop’s ancient insight that “a bird in the hand is worth two in the bush” provides the basics of a universal and immutable formula for evaluating all investment or lending situations where you are laying out cash now in expectation of receiving more cash sometime in the future. Therefore it applies to placing a value on all stocks, businesses, bonds, farmland, lottery tickets, oil royalties, manufacturing plants, and collectibles (to name just a few).

It’s worth reviewing this, the most basic of the rules and formulas of finance, because it is impossible to fully understand more complex aspects of finance and investment valuation without first fully understanding this basic concept.

Consider the case of the value of a dollar in your hand today versus the value of a dollar to be received in the future and where it is 100% certainĀ  that dollar will be received in the future.

A dollar in your hand today is worth more to you than a dollar to be received in a month, a year, a decade or fifty years. The most basic reason for this is that if you have the dollar on hand today you can choose to use it to buy and consume something today or you can chooseto hang onto it and buy something in a month, a year a decade or whatever. In the case of a dollar to be received in ten years you no longer have the ability to spend that dollar now or anytime between now and ten years from now. Rationally you will value a dollar today more highly than a dollar to be received in ten years. And this is universally true even before considering the risk of inflation or any risk that you will not in fact receive the dollar as promised in ten years.

Investments in the securities of strong governments like the U.S. or Canadian government are considered to be completely risk free. It is considered that if you invest in a U.S. government treasury bill or bond that you will – of a certainty – receive your money at the maturity date as scheduled. There can be no certainty regarding inflation but it is considered certain and risk free that you will receive your money back as promised.

As of today, the annual interest rate on a 10-year zero-coupon U.S. treasury bond is 2.25%. The market price today to receive $1.00 from the U.S. government in ten years is therefore 80.05 cents. Of course there are minimum dollar amounts that would have to be invested but the market rate is 80.05 cents invested today (effectively loaned to the U.S. government) gets you $1.00 in ten years.

The math works like this 80.05 cents times (1.0225) (to the power of ten) equals $1.00.

For various time periods the following table shows in effect the current value of a dollar to be received, on a risk free basis, in one month, one year, ten years etc.

Time delay before $1.00 is received Interest rate per year Value today ($1.00 divided by 1 plus interest rate to the power of the number of years)
One month 0.04% 99.997 cents
Six months 0.08% 99.96 cents
One year 0.13% 99.87 cents
Five years 1.01% 95.10 cents
Ten years 2.25% 80.05 cents
30 years 3.53% 35.32 cents

Applying Aesop’s terminology, we might say 35.32 cents in the hand is worth a dollar in the bush, if the $1.00 in the bush is going to emerge into our hand of a certainty in 30 years. Or $1.00 in the hand is worth almost $3.00 that will emerge from a bush and into your hand in 30 years.

Today’s interest rates (i.e. the discounts to be applied to money to be received in future) are close to the lowest in history. The reasons for that are numerous and complicated and I will not attempt to discuss the reasons in this article.

From the above table you can see that if you invest on a risk free basis there is almost no return available unless you are wiling to invest for at least five years.

If instead we invest in situations where there is some risk or uncertainty about whether we will actually receive the dollar when promised and/or where the amount we will ultimately receive is uncertain then investors require an expected return that is higher than and often dramatically higher than the risk free interest rates in the above table. It is often forgotten or left unsaid but when we speak of investors having a certain required return on a risky investment it is actually a required expected return. If the return were absolutely certainĀ (instead of onlyexpected) then the much lower risk free rates would apply.

Today’s market returns on risky investments such as equities (stocks) are not directly observable and vary with the perceived risk. The following table illustrates the value of a dollar at various required expected (but not certain) returns.

Time delay before an estimated but risky $1.00 is received Expected but not guaranteed return Value today ($1.00 divided by 1 plus expected return to the power of the number of years)
One month 4% 99.67 cents
Six months 4% 98.06 cents
One year 5% 95.24 cents
Five years 6% 74.73 cents
Ten years 8% 46.32 cents
30 years 8% 9.94 cents

The above table presents the discount that would be applicable to a risky dollar to be received at various times in the future based on the required expected returns indicated.

In Aesop’s terms the table above suggests that if the required expected return is 8% then $1.00 in the hand today is worth about $10.00 expected (but not guaranteed) to emerge from the bush into your hand in 30 years.

This concept of the the discounted value of a future dollar, also known as the present value is perhaps the most basic concept in the world of lending and investing. It truly pays to understand this concept.

Do Not Hoard Business Ideas

Have you ever had an idea for a new business venture? Have you hesitated to talk about it out of fear that people would steal your idea? My advice is don’t worry about such theft. It’s unlikely that more than one out of a hundred people that you talk to would seriously consider starting a new business venture in the next year or so. And of that one in hundred it is highly unlikely that they will share your passion for your particular idea. Business ideas are probably relatively plentiful. What is much more scarce is people with the money and the time and the drive and the guts and who are actually in a position to start a business venture in the near term.

So my advice is to go ahead and talk about your idea and get some feedback. It’s very unlikely that anyone will steal your idea (despite it’s brilliance).

I will share with you now a business idea that I have been thinking about for many years. It’s the idea of signing up home owners to have the maintenance of their homes professionally managed. Most people might never consider paying to have basic home maintenance done for them. But there are certainly a lot of affluent home owners who could benefit from such a service. Services that might be included under a flat rate might include: Yearly furnace cleaning, yearly dryer vent inspection and cleaning, empty and clean central vacuum annually, inspection of roof (on-roof) every three years, annual changing of smoke detector batteries or testing of wired in units, perform scheduled maintenance on washer, dryer and sump pump annually, inspect drains and plumbing annually.

Optional services could include lawn maintenance, annual window cleaning, snow clearing, visit and monitor house while you are on vacation, install and maintain decorative lights, change light bulbs in hard to reach places, attend to leaking faucets and drains as required, perform small handyman projects as needed, tree trimming, gardening.

Such services may already exist but they would seem to have a very low market penetration and I believe there is an opportunity for this type of business. You are free to “steal” this idea if you wish.

Solving the Pension Crisis

It is well known that defined benefit pension plans like those offered by governments and certain large corporations are now unsustainable. I have studied this issue and I have rather immodestly taken on the task of laying out the design for a sustainable and attractive pension plan in my new pension article. Read it to see if you agree with my design of a better pension plan.

Don’t Buy or Hold Long Term Bonds?

My updated article on the (lack of) attractiveness of long-term bonds suggests that they are poor investment to buy or to hold at this time, and especially long-term government bonds.

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Shawn Allen, President
InvestorsFriend Inc.

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