Junk Equities – Part Two

by Stefan Jovanovich, 9/7/20

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“Junk equities” has become the term our family office uses to describe the companies that have underperformed in 2020 even though their dividends offer a better yield than junk bonds. The label was invented by one of the members who suggested that we take seriously Jeffrey Gundlach’s recent remark that bond market investors should, “go to the areas where the damage has been observed and the Fed has not manipulated the price,” – i.e., junk bonds that do not qualify for Federal Reserve purchasing program. “Gundlach may be wrong,” she said, “to attribute the near-vertical increases in the quotes for favored tech stocks to the Fed’s elastic legal interpretations of its authority under the 1912 Act; but his observation deserves respect. We are back in the 19th century when stocks consistently yielded more than bonds.”

Under the structure of our family office, investment policy is decided by a majority vote of the members, not a tally of their respective shares. This follows the example of the weighting of shareholder votes by the articles of incorporation of the first Bank of the United States. As a result, the respect usually shown to the wealthiest people in the room is absent from family office meetings. The structure has also abolished all presumption that age and experience are entitled to automatic deference. Fortunately, even the youngest members accept the premise that market history is worth studying. Thanks to the internet, the “lessons” of financial history are available for anyone to study; and members for whom 2008-2009 is ancient personal history are just as concerned as us geezers about whether recent events are part of another “bubble.”

Neither the older nor the younger members have found it helpful to bring up the recent remarks of someone else I admire – Eugene Fama. In an interview, Fama was quoted as saying, “Bubbles are things people see in hindsight. They don’t identify them in advance. Sure, you can look at the behavior of prices, and you may be able to identify cases where they are too high. But if you only look back and say: ‘Oh, stocks went down a lot, so that was a bubble’, then that’s 20/20 hindsight. At the time, there was no evidence that there was a bubble.” He was equally discouraging about drawing any conclusions from the extreme concentration of total market capitalization among a small number of companies. “In the past, it’s always been the case that the largest 50 companies account for more than 50% of the total value of the market. Now, we’ve got a technological revolution, and it turns out that there are five or six big winners, these trillion-dollar companies. They are a pretty large fraction of the market, but they did it through innovation, not through theft or any other illegal behavior. So I don’t know why that’s a negative. These are all new businesses that provide new services we didn’t have before.”

As the oldest family office member, I have been given the nickname of, “the history channel.” Even the other senior members find it a bit of a stretch to think there is much wisdom to be found in what Anthony Trollope wrote about the 1840s mania for railroad stocks in Great Britain. As one reminded me, after reading my last article on the subject of junk equities, Trollope wrote the novel three decades after the mania happened; it is no more timely an observation than Dickens writing about the French Revolution in A Tale of Two Cities. My only defense to that point was that Trollope was writing about something that had happened in his lifetime. Dickens’ fiction was entirely a matter of imagination; his novel was published in 1859.

Gundlach and Fama’s observations can be integrated into a single thesis that helps explain the repetition of the 19th century inversion of bond and dividend yields. Fama’s irrefutable observation is that markets change over time because peoples’ discounting of the future changes; in that sense, prices are rationally logical because it is only in hindsight that prices themselves can be proven wrong. In the last third of the 19th century, investors in the United States and Britain accepted lower yields for bonds because of their presumed greater certainty. That presumption was justified by the activities of JP Morgan and others who made certain that, even in the worst recapitalizations, the original bondholders had their capital preserved. The rewards of owning common stocks, like the rewards of owning land itself, could enjoy extraordinary returns: Harvests, prices, earnings and dividends could all be “good.” But, against those results had to be discounted the odds that next year might be “bad.” There was a premium to be paid for certainty against the risks of fundamental uncertainty.

The yields of Treasury bonds and the Apple common stock (and debt) are taken as near certainties. So are the prospects of continued growth for the favored tech companies. The pricing of AAPL shares that with the issue discount for the Pennsylvania Railroad’s 50-year debentures offered to finance the tunnel under the Hudson and the station to be built in Manhattan. The portfolio of 15 junk equities that are now the family office’s holding of common stocks promises an annual dividend yield of 4.24% against cost. Its median, average, and cost-weighted average Pietroski scores are 6, 5.87, and 5.9.

In the age of Anthony Trollope, in hindsight, the variable cash returns of common stocks and their dividends deserved greater premiums; the certainties of fixed income coupons deserved lesser ones. Our family office is betting that a similar shift in market discounting will occur in this period in financial history.

Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.

Junk Equities – Part Two

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