“There is nothing new in the world
except the history you do not know.”
By Richard L. Kesner, President
The CommonWealth Group
February 2005
It is always amazing to me that investors think owning stock in excellently run companies is dangerous and owning bonds is safe. It is bewildering because history is very much on the side of owning stocks. However is you listen to the “talking heads on TV” or read the scare tactics of most financial publications they will tell you that stocks are risky and bonds are safe.
First, owning a share of equity common stock is nothing more or less than owning a share in a business. This is not gambling like going to Las Vegas. Owning quality companies is not “playing the market.” Second, if you look at the really wealthy people in America, you will notice that a great many of them achieve real wealth as owners of good businesses.
In order to start a business an owner might have to take a loan. The lender received collateral for that loan and the owner agreed to pay a specific rate of interest on the loan. However, no matter how profitable that business became the lender was only going to receive his loan principal back plus the interest. If the business was not profitable and eventually could not pay back the loan the lender would have to foreclose on the loan to try and recapture as much of his principle as he could. The lender’s only risk is his risk of capital and if he has done his research properly that risk should be minimal. Because there is not much risk, the lender does not receive much in the way of return.
The owner of the business has far greater risk. If the business fails and he cannot repay the loan he’ll see the major assets of his business or maybe the entire business being taken away. If he succeeds he gets to keep all of the profit and all of the increased value of the business above and beyond the face amount of the loan and the interest he has to pay the lender.
The next question is to see just how much more the owner would receive than the lender. The problem is that the future is not guaranteed. So how many years of past history would we need to use in order to come out with a pretty good idea of how the owner would do compared to the lender; 10,20,30,80? This is not a guarantee. However, we could probably come up with a reasonable probability based on past history if we could come up with a comfortable time frame for comparison.
The longest period of time for which we have the most reliable information for comparing stocks to bonds is the period from 1926 to 2003. This is 78 years and is a pretty fair definition of long-term. This period also takes into account the two longest deepest bear market in history, the greatest bull market in history, the nation’s worst economic depression and its greatest boom; global conventional war, the threat of nuclear extinction, the failure of communism and the terrorist attacks on September 11, 2001. The period includes times of deflation, inflation, high interest rates, low interest rates, Republicans in office, Democrats in office, just about anything you can think of.
The results are dramatic:
1. Small Cap Stocks……………….12.7%
2. Large Cap Stocks……………….10.4%
3. Corporate Bonds………………...5.9%
4. Government Bonds……………...5.4%
If we take inflation into account at the annual rate of 3% the returns are as follows:
1. Small Cap Stocks………………..9.7%
2. Large Cap Stocks………………..7.4%
3. Corporate Bonds………………...2.9%
4. Government Bonds……………...2.4%
Let’s add another important factor, taxes. We will use. For sake of an argument, a 28% tax rate which you can be debate as accurate or not:
1. Small Cap Stocks………………..6.1%
2. Large Cap Stocks………………..4.5%
3. Corporate Bonds………………...1.25%
4. Government Bonds……………...0.9%
From the Information above you can see that the owner of the portfolio of Large Cap Stocks got paid between 4 & 5 times what the loaner was paid. But what we really see is that the loaner got paid zero, nothing at all, and all of the real wealth went to the owner.
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