The Equity Yield Curve
The Equity Yield Curve, a phrase of our choosing, is one tool – and one of the most powerful – for identifying and visualizing the enormous level of return often available from securities that have been ‘discarded’ or ignored by conventional investment practices. It is all about a rather insubstantial thing: time or, more accurately, time risk.
Much like the more familiar bond yield curve, which has a positive slope most of the time – that is, higher yields for the risk of longer maturities – the equity yield curve has a positive slope. But the equity yield curve is decidedly steeper; go out to 3-plus years and you’ll find expected rates of return of 30% or more.
The equity yield curve is simply a visual depiction of the degree of disinterest by most investors in returns that seem too far away or, phrased alternatively, a depiction of time risk as those investors see it. Very occasionally, it can be plotted on a chart, as in the case study that follows. Now, this requires some explanation, because 30% seems ridiculously high – what kind of risk merits a 30% discount rate?
To understand that question, one must understand the trading needs of institutional investors, such as mutual fund managers, who show an overwhelming preference for securities that are perceived to have the potential for short-term positive relative returns.
The term “relative”, here, is important, because it is distinct from an absolute measure of return: 15% may be marvelous on its own; but, if the stock market was up by 16%, then 15% is, essentially, a failure. (Likewise, in a relative-return world, a decline of 15% when the market is down 16% is a success.)
Short term generally means within one year, and particularly prior to the calendar year end. Hedge fund incentive fees, for instance, are typically based on quarter- and year-end results. So managers are held, with often excruciating pressure, to these short term standards; it directly impacts their compensation, their career path, their ability to retain accounts and their jobs.
Put into security selection terms, stocks that have the possibility of outperforming the market in the coming year or so, with the obvious hallmarks such as rapid sales growth or an exciting new product or increasing analyst coverage, are in great demand. Crucially, though, securities not perceived as likely to perform within that time period are typically avoided, even if their long-term potential may be extraordinarily attractive. They are considered very risky – not because the stocks might fall, but because they might not go up when the market does! To a manager, that represents time risk, which must be avoided. Such a security, even one with tremendous potential, even if acknowledged by the manager, is of little use or, in investment-speak, has very little utility. This is what creates the discount for securities that might do very well, but either well beyond the artificial and abbreviated time horizon of the professional manager or with significant uncertainty about when such performance might occur.
How Is the Yield Curve Plotted?
In the overwhelming majority of cases, equity valuation is highly subjective: the elements of valuation (such as the rate of increase in earnings, the normalization of a disrupted business activity, or the appropriate P/E multiple) are not certainties but rather are subject to differing estimations and assessments. It is all arguable. After all, reasonable minds may differ. As a consequence, it is understandable that the notion of an equity yield curve, with implicit future dates and share prices, does not find its way into common discourse, and certainly not as a working model. Occasionally, though, if rarely, these factors do converge, at least with as much certainty as can be had in the investment world. The following example, one of several we once collected, shows how certain securities can be employed to actually plot the equity yield curve.
Case study: Johns Mansville
Johns Manville, a major manufacturer of packaging and buildings products (including, unfortunately, fiberglass insulation), was the first major asbestos liability-related bankruptcy. It emerged from a 6-year bankruptcy proceeding in 1988 with a reorganization plan that created two trust funds to compensate claimants. The plan ceded ownership to the trusts of 80% of the shares and 20% of annual profits, so that the claimants were in the unusual position of owning the company, with a natural self-interest in its financial success.
More importantly, the court permanently enjoined any further asbestos-related cases against the firm, removing this legal liability from the valuation equation. The company did not historically exhibit unusual business or credit risk: it was profitable before the 1982 bankruptcy and remained so, with a 1989 interest coverage ratio of 3.7x, a 45% debt/capitalization ratio, operating cash flow of $413 million vs. long-term debt of $802 million, and a current ratio of 1.5x. In 1990, the company reached an agreement with the trusts to pay dividends to common shareholders.
There did exist, however, an unusual Manville security, which is the subject of this example. This was the Johns Manville preferred, which had a cumulative preferred dividend of $2.70 per share and a $25 liquidation preference. An odd feature of this preferred was that the first dividend was not payable until March 1994, well over three years into the future. Furthermore, it was not callable until March 1994, although it appeared that the company would most likely wish to do so since the stated dividend yield, at over 10%, was well above market rates.
Yet, as of year-end 1990, with over three years to a known date and future value, the preferred traded at $9, which would provide a 38% compound price return to the March 1994 dividend commencement and call date, and a contingent (if not called) 30% dividend yield. The offered returns would seem excessive indeed, considering, by that time: the substantial resolution of the legal risks, the unique circumstances that the interests of the claimants were fully aligned with those of the management and minority shareholders (maximization of profits, share price and trading liquidity), the financial health of the company and the company’s clear financial capacity to redeem the preferred at $25 per share, either outright or by refinancing the 10.8% stated yield at lower rates. The following prices for the preferred shares were observed:
Therefore, in this example, the equity yield curve can be plotted as follows:
The chart above should be read like a bond yield chart, indicating that with three years left before the dividend date, the highest potential annualized return of 38.1% could be realized, whereas with just a few months before the first dividend payment (closer to “0” on the horizontal axis), the annualized return had declined to just 3.1%, almost identical to the yield on a three-month Treasury bill at the time.
It has been observed that the equity yield curve flattens out over the last few months prior to the expected event: the market is very efficient when very little time remains before the triggering event, but increasingly inefficient when the event is 12 months or more away, or increasingly indeterminate. Fund managers’ reluctance to purchase such securities is expressed in the discount rate. To take advantage of this aberration one merely has to extend one’s time horizon. From the professional manager’s perspective, this requires the willingness to take on time risk.