Cash, Bonds, and Stocks: What’s in Your Portfolio and Why? (Part 2)

Paul Winkler: Okay. We’re talking the basics of investing.

We’ve talked about cash. We’ve talked about bonds. Now we’re talking a little bit about stocks.

Arlene Brown: Exciting.

What the Investment Industry Pushes

PW: We’re going to get a little bit more into the stock market. This is the fun part.

AB: Yes.

PW: Yeah. The stock market’s pretty cool. So did you ever do preferred shares or anything like that, Arlene, when you were working for Merrill?

AB: No.

PW: Did you ever get in that?

AB: No.

PW: Good for you.

AB: We never. Yeah.

PW: Yeah. Did you ever get in real estate investment trust? You did? You can confess.

AB: Very good commission.

PW: I know a lot of investment firms I hear advertise all over the place that sell that garbage, and people don’t know what they’re getting into …

AB: Well, I did not know.

PW: … until it’s too late.

AB: Yeah.

PW: But yeah, it’s one of those things we were pushed hard to do. I just never felt comfortable with it, just because I didn’t feel like I understood it well enough. But we were pushed to do it. We were pushed to do oil and gas futures.

AB: That I did not do.

PW: Oh, yeah. Yeah. We were pushed to do it, but I didn’t sell it because it was, again, one of those things I learned a lot about, and I thought it was interesting. Those types of investing — low-income housing was another one that we were really pushed heavily to sell to the public — I never really sold any of it.

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I was a horrible salesperson because I would study it so much, come to the conclusion that it was bad for people, and not do it.

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AB: You know what I never sold?

PW: What’s that?

AB: And it was really big with Merrill Lynch and American Express. It was variable annuities.

PW: Really? You never did that?

AB: Not that I never wanted to.

PW: I feel sorry for Peyton Manning. He’s out there advertising for Nationwide.

AB: But I couldn’t sell.

PW: And Nationwide is pushing that stuff like crazy.

AB: I couldn’t sell.

PW: Yeah. Yeah.

AB: But I sold a lot of fixed.

PW: Did you?

AB: Just the fixed annuity, the simple fixed annuity.

PW: I sold one.

AB: Straightforward.

PW: I sold one.

AB: Yeah.

PW: Yeah. You’re ready for my confession, public confession?

AB: Aha.

PW: I sold it to my mother-in-law. I know. I know. Sorry.

And I like my mother-in-law. That was the sad part about it. You don’t do that to somebody you like.

AB: Well, because in the ’90s, fixed annuity and variable annuity, you sold it to the teachers.

PW: Oh yeah, yeah, yeah, yeah, yeah. Yeah, absolutely. Yeah.

AB: So, yeah.

PW: Yeah. Jim Wood, one of our guys, used to do a lot of that stuff. Yeah.

AB: Yeah.

PW: He thanks his lucky stars the way he got away from that.

AB: Yeah.

Competitive Markets

PW: Okay. So, back to stocks. Okay. So when we’re looking at the stock market, and two ways that companies raise money to operate is one, they will borrow it, but they have to make interest payments.

And if they can’t make the interest payments, they’re going out of business because they’re going to default. And companies recognize that. So they watch how much money they borrow for operations.

If they don’t know what their profitability is going to be in the future or it’s going to be a while before they’re profitable, they will issue stock and that is hence why the stock market exists. It has been a way for companies to raise money for operations.

And the stock market, you have exchanges around the world where stocks are traded. Back in the early days in Wall Street, you’d get people standing around posts. They would stand around posts in the street or they would even be in bars or they would be someplace … you would have a place that you went where you knew a certain stock was going to be traded.

If you wanted to buy X, Y, Z railroad, you knew that there was a place where people that owned X, Y, Z railroad stood, and you could buy it from them, and you could sell them shares. You had people that are called market makers.

They made a market in X, Y, Z railroad stock. So hence that’s where the term post came from.

You hear the post of the New York Stock Exchange. You heard that. That’s where the term came from.

Now, when we talk about companies, you have to have somebody that owns, that makes a market for it. This is not unlike Kroger, Walgreens, right? They make a market for Colgate toothpaste. They make a market for cold medicine.

And you’ll have competitive markets. You’ll have Kroger and you’ll have Walmart and you’ll have Walgreens and you have Eckerds and you have whatever. You have all these places that hold an inventory, Publix.

They hold an inventory in that particular toothpaste. If Kroger charges too much for it, I’m going to go over to Walmart or Walgreens or wherever. If one place charges less, I’m going to go there.

That’s what makes markets work is because you have this competitive marketplace where people are making a market for these things and I can buy this thing. Now, this is something that big investment firms, I won’t name names like Robinhood, but they will actually direct the trades to companies that charge more and tell you that they’re not making anything off the transaction.

This is common knowledge. I’m not saying anything that’s not common knowledge. They call it … it is a … what is it?

AB: Flow.

PW: Come on. Payment.

AB: Flow.

PW: Yeah, flow. Order flow.

AB: Oh, yes. There you go.

PW: Yeah, thank you. Yeah. Yeah. It escaped me for just a quick second there.

But yeah, so you have order flow. And so that is something, if you ever want to look it up and see what that is, you can actually go and use that term and look it up and see what we’re talking about.

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But you’ve got to really, really be careful because companies that charge you nothing for trades, they’re making money in another way.

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They’re not running a charity. There are other ways that companies can make money. Payment for order flow is one of them.

Paying Out Earnings in Dividends

PW: Okay. So back to stocks. So we break this company up into lots of different pieces. Recognize that a company is using your money.

They are using your money when it comes to stocks and bonds. When they use your money in bonds, they have to pay you interest. When they use your money with stocks, they pay you …

AB: Dividends.

PW: Yes. Which is a subset of earnings. So a company earns money on whatever it is they’re selling.

So they sell something, they pay their expenses, their costs. They have operating expenses. They’ve got to pay their employees. They’ve got interest expenses, maybe they have taxes.

And then what comes after all of that is earnings. Now those earnings get split. Part of them are paid back to the shareholders, and that’s a dividend.

The other part is retained in the company. So a company wants to do something. They want to, name it, Arlene. What might they use those earnings for?

AB: Well, they can buy inventory tracking systems. They can buy big whatever or expand.

PW: Expand. Yeah. Yeah, expanding in new markets.

Maybe they can buy another distribution center. Maybe they can buy an AI computer system.

AB: There you go. There you go.

PW: And they’re going to retain their earnings. Now, why would they buy an AI system? Because it’ll make them more productive in the future.

AB: That’s the expectation.

PW: Well, then, why would you do it? You would do it because maybe you could be even more profitable.

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So companies that pay out all of their earnings in dividends have run out of ideas. 

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It’s another way of looking at it. So people will buy stocks that pay high dividends and think, Oh, I’ve got this stock and it pays a really high dividend. And what they don’t recognize is they may be just buying a company that doesn’t have a lot of growth potential, that there’s not a lot going on. And it’s not necessarily always a positive if they have high dividends.

But it’s a sales pitch that we often hear. “You need dividend paying stocks for your retirement money.” “Oh yeah, I want a bunch of companies in my retirement portfolio that have run out of ideas and they have nothing better to do with their money than pay dividends in excess to me because they can’t think of anything better to do with the money to grow the company in the future.” “When you put it that way, Paul, it doesn’t sound so good anymore.”

“I want a bunch of distressed companies in my portfolio now that I’m in my 70s.” Maybe not the greatest idea.

So that’s what they’ll do. Now the payment, they’re paying you to use your money through paying out the earnings to you in two ways, retaining that back in the company. You still own the company, so those earnings are still yours. And they’re paying you out that dividend.

Where Returns Come From

PW: So what happens is this. Now, this is the way I like to explain where returns come from in stocks.

Where do people think returns come from in stocks? “I’m going to buy this company for $60, and when the public figures it out and it goes up to $70, I’m going to sell it, and that’s how I make money. I buy it for $50, I sell it for $70, that’s how I make money.”

You’re assuming that it’s mispriced, selling for $50, and when it goes up to $70, you’re going to sell it, and that $20 gain is where the returns come from. There is a way better way of understanding this, a way better way of understanding this.

Now, in my book, “Confident Investing,” I get into great detail using what’s called the Gordon Growth Formula, which is something Eugene Fama, Nobel Prize winner in 2013, taught me. But the way I like to explain it to keep it simple, stupid — and I’m not calling any of you guys stupid. I’m saying that’s just my thing. It keeps it easy.

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It’s much better to do it this way: to look at what price I’m paying for each dollar of earnings.

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Now, historically, S&P 500 sells for what, Arlene?

AB: Fourteen? Sixteen.

PW: About $16 for every dollar of earnings. So I get a dollar of earnings for every $16 I pay. If I have a company with a billion dollars of earnings …

AB: And it’s paying 16.

PW: And I want to buy the whole company, I got to pay 16.

AB: Billion dollars.

PW: Yeah. And let’s say if the earnings are a billion this year, a billion the next year, a billion year after that, a billion the year after that, a billion the year after that. Now it never works that way, right?

Earnings go up, down, up, down, up, down, up, down. Hence, the reason the stock market goes up and down.

Historical Rate of Return

PW: But historically, going all the way back a hundred-plus years, the S&P 500 has sold for about $16 for every dollar, $1 of earnings. So if I take one divided by 16, that is what’s called the earnings yield. If I have a CD that pays 3% interest, I get $3 for every …

AB: One hundred dollars.

PW: So one, my 3% return is $3 of interest for every $100. That’s 3%. Just like that, I get a dollar of earnings as long as the earnings continue in the future with my stock and I pay $16 for that. One divided by 16 equals …

AB: Six point twenty-five.

PW: Six and a quarter percent. Right. Now my earnings grow.

Well, let’s say that they grow three to four percent. I take my 6.25%, and my earnings growing at 3% to 4%, and hence the return for every 30-year period in the stock market. All of history for the S&P 500 is around what?

AB: Ten percent.

PW: Yeah, plus or minus one. So if I go 1926 just before the Depression, all the way to 1955, rate of return?

AB: Ten percent.

PW: Ten percent. You believe that? Ain’t that crazy?

In 1927, 1956, about 10%. In 1928, 1957, about 10%. In 1929, yeah, to 1958, yeah, it’s a little bit less, about 9% though.

Around 9%. Not much less, but just a little bit less.

But historically, that rate of return is right around that, within spitting distance of 10% return. So hence, we look at that and we say, “Wow, that’s where returns really come from. It’s cost of capital.”

Warren Buffett basically said, and he’s a pretty smart guy, he said, “Stocks are bonds in disguise.”

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Stocks are bonds in disguise. 

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And he said, “Literally, you’re just getting paid a different form.” Instead of getting paid interest, you’re getting paid earnings.

And that is what to me was, oh my goodness, my eyes blew wide open when I learned that, because I had never, ever thought about it that way. Now, after this break, I’m going to walk through, okay, so we get stocks, we own different types of companies — what are the different types of companies that we might own?

AB: No, we’re getting exciting.

PW: All right. And you’re going to name some of the different areas.

AB: Sure.

PW: I’ll have you talk about sectors, Arlene, right after this.

Stock Market Sectors

PW: All right. So we’re getting into the basics of investing. The basics. When we look at investing, we say, “Okay, so what are the things that you really, really need to know?”

You need to know something about cash. What is cash? We talked a little bit about how cash is something absolutely stable. No fluctuation in value.

Bonds, they’ll fluctuate in value a little bit. And then you’re making sure that you don’t have too much fluctuation because bonds are there for safety.

The right types of bonds tend to go up when the stock market goes down. That’s the idea behind the better types of bonds for an investment portfolio.

There are different types of entities that will buy these other types of bonds, but I don’t want to be a part of that. Not in my investing, because when we’re investing for the regular household or somebody trying to be their own pension plan, you’ve got to be really, really conscious of following the rules of investing and following prudent investing rules and principles.

I may get into that in the course of the show, because there’s actually some legal precedent for some of the things that I’m talking about as to how to invest. So we’ll get into that if I have time.

Okay. So we talked about the stock market, how stocks work. You’re owning the companies, you’re getting paid the earnings of the companies.

Now, different sectors. You have different areas of the stock market. What are some sectors that come to mind for you, Arlene?

AB: You mean large companies?

PW: No, sectors.

AB: Sectors. Okay.

PW: Not asset classes. Let’s talk sectors.

AB: Energy.

PW: Energy. Sure.

AB: Energy.

PW: Yeah. Energy is going to be one.

AB: Consumer.

PW: Consumer staples. Consumer durables. Yeah.

AB: Financial.

PW: Financial would be another area.

AB: Insurance.

PW: Sure. Insurance is technically …

AB: Yes. It’s technically a sector now.

PW: Yeah. Yeah. And it’s going to be part of your financial. Sure.

AB: And then technology.

PW: Yep.

AB: Information technology.

PW: So these are all sectors. It’s a subset. When we talk about the S&P 500, in the S&P 500, you will have all of these different types of companies in there, different sectors.

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Does it ever make sense to go and own sector funds? Uh-uh. No way. I would not do that. 

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And the reason being, what I’m doing is if I go, I think I’m going to own a financial fund. I think I’ll own a consumer durables fund. Now I’m getting into market timing.

Why would I own those individual sectors? Because I believe that that sector is going to do better than one of the other sectors. That’s the mistake.

Tactical Asset Allocation

PW: We started off the show with a quote from John Bogle talking about how these mutual fund companies actually started these different funds in the ’90s in order to suck investors in. Because from a marketing standpoint, they thought technology was going to go up forever, and hence they could sell this stuff to you.

When we talk about energy stocks, people get excited about energy stocks at the worst times: after energy has gone up in value. So when owning a specific sector, what you’re doing is you’re assuming.

Let’s say if I buy a certain sector fund, like a technology sector fund, or a retail sector fund, or an energy sector fund, I’m assuming that the companies in that sector want to pay me more to use my money than another sector. That makes no sense whatsoever.

When the technology world is hot, those people that are running technology companies don’t want to pay you more. Matter of fact, they’re more likely to want to pay you less to use your money. And they may be able to get away with paying you less because their sector’s hot. It’s the exact opposite of what we might think.

Go ahead, Arlene. You look like you’re about to say something.

AB: No, it just brings memories about how we were taught.

PW: Oh, it’s so true.

AB: I mean, it’s like, “Okay, you talk to your clients that based on our research department, banking sector is going to go down in the next three months.”

PW: Yes.

AB: And then, utilities are really, really going to ramp up the next quarter.

PW: And it sounds brilliant. It sounds brilliant.

AB: It makes sense.

PW: Like, “Wow, these people are really on top of things.”

AB: The way it was explained, it really makes sense and is compelling. And I remember our clients would just eat it up.

PW: So true. So true.

AB: And it’s like, “Yeah, yeah, there you go. Our commissions are good.”

PW: You’re absolutely right. And when you ask them, “Arlene, aren’t you market timing?” And they go, “Oh no, no, no, no, no. That’s not market timing.” It is.

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It is what is called tactical asset allocation. It is a form of market timing that’s very subtle. 

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It’s very, very attractive sounding, but it is a form of market timing because you’re assuming that banking is overpriced, as she said, sell it. And that, what was the other one? Was it energy?

AB: Utilities.

PW: Utilities are underpriced, and it’s time to buy that. So what I just said, “time to buy that,” implies what? Market timing. It is exactly what that is.

But they will tell you, if you ask them, “Do you market time?” They will tell you, “No, no, no, no, no. That’s not what we do.”

But I’m telling you that is the typical modus operandi of the investment industry. So sectors are a no-no.

We’re going to talk about in the first part of next hour, we’re going to talk about asset classes. Now that is good, valid stuff to look at. When we put together an investment portfolio, we want to look at asset classes, not sectors, and we’re going to get into what those are in just a second.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.