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In these uncertain times, investors need to start looking for 'equity bonds'

In the face of an uncertain economic future, search for "equity bonds."

The past few weeks in the United States have been like an erupting volcano. A new political administration is rolling in with huge changes promised in economic and foreign policy. With policy changes come a host of unknown outcomes that we will be dealing with during the next several months and years. Amid all this turmoil, what is an investor to do?

Our answer is to stick with the tried and true. In our world, we stay with our bedrock idea: the search for "equity bonds." Warren Buffett introduced this term back in 1977. It struck me as a brilliant, succinct term that describes exactly what we search for. The rare but highly sought after financial gem helps to ground us in these turbulent times.

An "equity bond" sounds like two different investment concepts. Bonds pay a predefined amount of money at specific times called coupons. On the maturity date of the bond, a predefined amount of money is returned to the investor. Equities, as Mr. Buffett points out, have a maturity date of infinity with varying rates of return over time. It is the nature of businesses that we don't know exactly what their coupons will be. So, how can these two ideas be put together?

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Mr. Buffett makes the critical point that "… stocks, in economic substance, are really very similar to bonds." Further on, he notes that, "Stock investors, who are in general not aware that they too have a coupon, are still receiving their education on this point." It is truly amazing that almost 40 years have passed since he wrote these words, and investors still haven't picked up on this important lesson.

There is the link between what at first glance appears to be two very different vehicles. In an economic sense, an investment is the purchase of assets that are not consumed today but will be used to create wealth. A successful investment is putting a dollar into the ownership of some enterprise or fixed-income investment and receiving more than a dollar back at some time in the future. The important idea here is that the expectation is the same, whether it's a bond or equity investment.

So while the two terms on the surface – "equity" and "bond" – appear very different, the objectives match. The big question for an equity investment is: What is the coupon?

In the case of equities, it is very difficult and, in most cases, impossible to figure out what that coupon will be. Let's look briefly at a sample of tough enterprises to get this answer and why. First, consider companies that are engaged in the business of extracting and selling commodities. They participate in industries in which an individual company has no control over the price they can command for their product. Earnings vary widely year to year by factors beyond the company's control.

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Second, retailing in general fits here. There is often a small or no barrier to entry into the sale of food, clothing or electronic devices. The struggle for customers' purchasing dollars is fought out on the battlefield of who offers the lowest price. I believe Mr. Buffett said it best about such enterprises: "You are only as smart as your dumbest competitor." If a company is desperate enough to gain market share by selling the same product you are offering at a loss, what choice do you have but to match that irrational price?

Some industries provide coupons that are far more predictable. For example, cellphone network providers are not exposed to the same unknowns as commodity-linked companies or retailers. Contracts dictate the monthly revenue each customer pays. Of course, there will be some churn, but the monthly revenue will never be cut in half by surprise price decreases.

Company-specific attributes are important when looking for a predictable coupon as well. Attributes we think are crucial include a sustainable competitive edge, small required capital inputs over the long haul, top-line growth, increasing free cash-flow generation and terrific people in charge of managing the business. The net result is that the investor has a reasonably accurate estimate of what range the coupon will be in.

The beauty of equity bonds purchased at a bargain price is that you don't have to worry about trying to get to an exact valuation number. Even if the coupon comes in at the low end of your prediction, it is still a very respectable return. Most important, you have reduced your risk of a permanent loss of capital. Purchasing an equity bond at an excessive price and hoping the coupon will come in at the high end of your prediction is just that: hope. In case you are wondering, hope isn't an investment strategy. The combination of coupon predictability and buying at a bargain price is likely to deliver to you the desired outcome – low risk and higher returns. Even if an unforeseen negative event happens to the company you will, at worst, make a smaller return than originally calculated.

When Mr. Buffett wrote his article, he stated that the market equity return seemed to be stuck at 12 per cent based on book value, and that would vary depending on what multiple of book value you paid. Return on equity (ROE) for the market as measured by the S&P 500 index on average for the past 10 years has been about 17.4 per cent, according to Barron's. Factor in that the multiple being paid on book value today is 2.8 times. This means the current investor is earning a return on equity of 6.2 per cent (17.4 divided by 2.8) – hardly a number that should excite any rational investor.

My conclusion? That's the going rate of return these days, take it or leave it. But it won't always be. Now that you know what to look for, keep an eye out for the elusive equity bond when prices come down.

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Larry Sarbit is the CEO and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a sub-adviser on three funds for IA Clarington.

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