I just finished The Bond King, Mary Childs’ book about the investor Bill Gross.
Bill Gross is the investing mastermind behind Pimco — one of the world’s biggest asset managers — and who more or less invented the idea of bond trading.
Half of The Bond King is about how the Pimco guys (all guys) mastered the precise, logical world of bond investing. The other half is about the dysfunctional way they treated each other, and failed to understand each other, until eventually the firm came close to imploding and Gross got forced out.
Gross learned late in his life that he had Asperger’s syndrome, which made sense of a lot of things. He was at his happiest at his desk on a silent trading floor, absorbed in multiple screens of markets data.
He avoided eye contact with his colleagues, and demanded everyone else on the trading floor be quiet at all times, and couldn’t understand why they acted the way they did. One can imagine the strange culture a co-founder like Gross instilled in Pimco.
He was good at his job. The returns on offer from his Total Return fund made it, for a time, the biggest He was good at his job. The returns on offer from his Total Return fund made it, for a time, the biggest mutual fund in the world, with nearly $300 billion in assets. For that, Gross was paid annual bonuses of up to $300 million. Pimco has been active in Ireland too, teaming up with Tetrarch Capital to buy real estate and Goldman Sachs to buy mortgage portfolios. It has a busy office in Dublin’s IFSC.
Bill Gross is one type of investor — highly intelligent, logical, mildly autistic, grinding out a couple of basis points every month.
That type of investor has not been in the ascendant for the last few years.
Lately the market has felt more emotional. The Gamestock thing. The Bored Apes. Elon Musk anointing this or that company or crypto as the next big thing. The loosey-goosey venture capital funds like Tiger Global, that pride themselves on shovelling money out the door faster than the competition.
You could be forgiven for thinking that was what investing was about: buying the hot thing before it went up even more.
But at its core, all investing can be reduced to one formula: a discounted cash flow. That’s what every investment, from stocks to bonds to property, even crypto, is about. The yardstick by which all investments must be justified.
Sometimes the market loses the run of itself and forgets about the formula. But the formula reasserts itself eventually.
Jack Bogle, the founder of The Vanguard Group, said, “Sooner or later, the rewards must be based on future cash flows. The purpose of any stock market, after all, is simply to provide liquidity for stocks in return for the promise of future cash flows, enabling investors to realise the present value of a future stream of income at any time.”
Cash over risk
So how does the formula work? An investment is, by definition, a claim on future cash flows.
A discounted cash flow analysis takes those future cash flows and discounts them back to the present day.
It’s a simple equation with a numerator and a denominator. The numerator captures all the cash an investor is going to get. In the case of a stock, it means all the cash generated by a company that’s left over after tax and, after it has reinvested in itself. It’s the cash this year, and in future years, as earnings grow.
In the case of a bond, the numerator would be the coupon payments plus the face value.
In the case of a Bored Ape NFT, it would be the capital gains from selling the thing to another “investor” in a year’s time.
The bigger the numerator, the more valuable the stock or bond or bored ape.
The denominator is the sum of all the bad stuff that may or may not happen to get between you and your cash flows.
Each individual bad thing gets expressed as a percentage. All the percentages get summed together. The higher the percentage, the greater the risk that you’re not going to see your cash flows, and the less valuable those cash flows will be in the here and now.
Imagine a company that generates €50 million in free cash. Now imagine that the risks in the denominator sum to 10 per cent. That company would be worth €500 million, because 50 / 0.1 = 500. If the risks in the denominator summed to 20 per cent, the company would be worth €250 million.
What kind of risks are we talking about? Inflation is one. If the currency in which the company’s profits are denominated goes through inflation, the currency will be worth less and so will the cash flows. Likewise for a bond.
For a company, there’s a category of risk called the equity risk premium. It contains all the things that can cause a company’s profits to go down in future. Everything from a competitor stealing its lunch, to new laws being passed, to new technology making its products obsolete. The equity risk premium varies from country to country. In safe stable countries, like Ireland, it’s in the mid-single digits. In unstable countries like Argentina it’s in the mid-teens.
Different industries carry different levels of risk. The ones with more debt are riskier. The ones with high fixed costs are riskier. And the ones whose products are discretionary — ie where purchases can be deferred — are riskier.
Airlines are risky because they have high fixed costs, and their product is discretionary. Construction companies’ product is highly discretionary. That’s why a euro of airline or construction company profit is worth less than that of a water utility or a grocer.
Private companies are riskier than public ones. That’s because when you buy a private company, you buy the entire thing; but when you buy a public company, you only buy a share of it. The share is part of a diversified portfolio. The ownership of a private company is not.
And then there’s the interest rate, which is your opportunity cost of making the investment. The higher the interest rate, the more you could have made sitting around taking zero risk. And the lower the value of your investment.
Interest rates are rising. The rising interest rate number is getting fed into a million spreadsheets and mechanically reducing the value of a million assets. But more than that, the end of low interest rates means you want stuff that pays real cash in the near term, not speculative investments on Bored Apes, or companies far from profitability.
The Bill Grosses of this world are getting the last laugh.