How corporations evaluate and use investment capital provided by individuals. Why companies find it easier to buy back stock rather than invest in capital projects.
In this episode you’ll learn:
- What is an autocallable contingent note.
- How do companies create value.
- What is a company’s cost of capital.
- What is net present value and internal rate of return.
- What is the difference between finance and accounting.
- How stock buy-backs increase a firm’s value.
- What is a derivative.
Show Notes
The Wisdom of Finance: Discovering Humanity in the World of Risk and Return by Mihir Desai
Finance For Executives by Gabriel Hawawini and Claude Viallet
Why Nelson Peltz Wants P&G To See Him As a Constructivist – New York Times
The Goldfinch In Winter – W. Ben Hunt
Product Design and Financial Literacy – Kingsley Jones
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Summary Article
An Inappropriate Investment
I recently received an email from a listener to my podcast who shared with me some investments that a broker sold to his father. There were 7 or 8 of these investments that comprise 8% of the gentleman’s net worth. The broker received a 3.5% commission for each sale.
The investor is in his late nineties. The life expectancy of a 97-year old man is 2.5 years. 97-year olds typically should invest in relatively liquid investments so that when they pass on it is easier to settle their estates.
These particular holdings are not publicly traded and have a three-year term. That means there isn’t a secondary market if the securities needs to be liquidated early. The issuer, PNB Paribas, is quite clear that if an investor wants to sell early they will likely receive significantly less than the invested amount.
97-year olds should also invest in investments they can understand. I don’t know this investor personally, and while my listener indicates his father is still sharp mentally, let me just say that despite my having an undergraduate degree in Finance, an MBA in Finance and well over a decade of professional investment experience, it took me more than an hour to digest and understand the 23-page document describing an example of one of these investments.
Autocallable Contingent Income Notes
The investment is an “Autocallable contingent income note linked to the worst of American Airlines Group Inc, Delta Airlines Inc., Southwest Airlines Company and United Continental Holdings Inc.”
It is a note that pays out at a 9% annual rate. That seems like an attractive yield except that the note will automatically be redeemed if every one of those airline stocks rises in price from their initial price when the note was issued.
In other words, the note does well if the airlines stocks don’t do so well. But the airlines stocks can’t do too poorly either, because if one of those stocks falls by more than 50%, then the note stops paying its 9% coupon.
After three years if one of those stocks is still more than 50% below its price at the time the note was issued, then the investor will take a significant loss on the holding. For example, if one of those airline stocks falls 60%, the investor would lose 60% of the principal value invested.
Simpler Investments
Investing used to be more straightforward before investment banks invented autocallable contingent notes.
An investor could buy a bond or a fund that invested in bonds. A bond is a debt instrument issued by a corporation that pays interest and will return the principal amount at maturity assuming the issuer doesn’t default.
An investor could also buy a stock or a fund that invests in stocks. A stock is an ownership interest in a company. The investor can receive a portion of the company’s profit in the form of a dividend. Some stocks don’t pay dividends because company management believe they can earn a higher return reinvesting those profits than the investor can.
Bond and stock investors or their fund managers are willing to allocate capital to a specific company because they believe the company’s management will not only meet investors’ return expectations, but exceed them.
Here is how Mihir Desai describes this process in his book, “The Wisdom of Finance.” “Finance’s answer to the question of where value comes from is simple—the capital you’re entrusted with has a cost because the people who gave it to you have expectations for return. Their expected return is your cost of capital. You are a steward of their capital, and the sine qua non of value creation is that you have to exceed their expectations and your cost of capital if you want to create value.”
Companies Use Investment Capital
Firms who continually undertake projects, such an airline investing in new planes or new routes, that generate returns that exceed the weighted average cost of their debt and equity capital, become more valuable. Their market valuation as reflected in their equity share price increases.
These firms give back more than they take. They create value. Firms that undertake investment projects whose returns fall short of their financing costs destroy value.
An autocallable contigent income note is not an investment in that corporations did not use the capital on a productive project. The money stayed with PNB Paribras after paying the broker’s commission.
Derivatives
An autocallable contigent income note is speculative derivative contract. A derivative is a security whose price or performance is dependent on what happens to another asset.
Derivatives aren’t bad. They can be used to hedge risks including unexpected calamities. Homeowners insurance is a type of derivative contract as the payout is contingent on what happens to the house. It reduces the homeowner’s risk.
Derivatives can also be used to speculate. Speculation involves purchasing a higher risk security where there is disagreement on whether the return will be positive or negative.
Speculation
Speculation isn’t bad either as long as the investor recognizes for what it is.
The problem with a broker selling an elderly investor an autocallable contingent income note is it could be misconstrued as a fairly safe income strategy when in fact there is a risk of significant loss.
Perhaps this investor knew the risks, but I suspect many purchasers of these securities don’t and their lack of liquidity certainly make them inappropriate for an investor who is in his or her late nineties.
