Financials in a fixed income account

Sounds like it depends on what definition you are using for "financials". I think generally, "financials" refers to a very diverse number of companies whose principal business consists of lending money, whether for construction, equipment, or consumer loans. A bond is not, as far as I understand, a "financial", but could be classed that way if issued by a company whose business is, for example, banking.

Traditionally, a fixed income portfolio would contain interest-bearing intruments (such as bonds), or high yield preferred stocks - such as you have. The idea is that bonds will not default, so the principal is safe. Preferred stocks may be "cumulative preferred" - their dividend is (given a priority) subordinate to interest, but senior to the common stock, and if suspended, continues to accrue (cumulate) and will be paid out when the dividend is restored. There is some additional stability in preferred stock, due at least in part to the higher dividend payout. But the principal in bonds and preferreds is also subject to loss of purchasing power due to inflation. Thus when T- Bills fall below the rate of inflation, they actually pay "negative interest". Other classes traditionally found in income portfolios are utilities, municipal bonds, and perhaps some CD's.

With interest rates at their current low levels, many dividends paid by non-financial companies are higher than most interest rates. An important factor not to be overlooked is that many companies have steady earnings increases from year to year, and a history of increasing their dividends. A screening program can give you high dividend payouts, but there are all the factors of the company to be very carefully considered before buying shares of the stock. Your time frame is an important factor to consider - the longer it is, the more time you have for dividend increases, and the less you have to worry about overall market vagaries up and down. But you always have to look very carefully at the underlying business of the company.

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Dapperdobbs, my sincere appreciation for one of the most complete and concise answers I have ever received on this subject.

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Keep in mind that the high dividend % currently being reported may be misleading. Many stocks have fallen in anticipation of reduced earnings making the past dividends look overly attractive.

Anoop

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First, to be very clear about what we mean by "financial issues" here, most likely your account's decline was due to bank-issued preferred stocks and/or bonds.

Second, I assume by "fixed income" you mean income that will not adjust with inflation and so is pretty much the same dollar amount year after year. If so, I would expect a "fixed income" account to hold high grade corporate bonds; government bonds; and preferred stocks. When it comes to preferred stocks, one can peruse quantumonline.com to see what is typical. Use its screener (under "income table"), and filter by company type. Banks and financials are about 300 of 1200 preferreds. So I would say your advisor is being accurate.

I am studying what has happened with banks this past year or so and propose another question: Should we as investors expect managers of our fixed income accounts to take more care? I think overall this would be asking a little much. First, I propose the mission of a fixed incom account's manager is to preserve income first and be less concerned with the principal's fluctuations. Second, it seems to me the decline in banking securities happened rather quickly; people, even those in the business of investing, got caught off-guard. Third, what would the manager buy in place of the sold bank securities? Fourth, if the bank preferreds etc. started as pretty high grade, chances are they have downgraded but not all the way to junk, meaning your income should remain safe. Fifth, I would wager it's been over a decade since bank preferreds and bonds have seen such a massive downturn. Fact is that many banks' credit obligations were not obvious.

To me, the only argument that might counter this is that banks are inherently risky. Banks' common stock P/Es historically are well below the P/E of the S&P. This is evidence of the risk. Should a fixed income account manager therefore have fewer bank preferreds and bank bonds? I would say no, because high grade preferred and bonds have more safety built into them, as dapperdobbs describes.

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The common shares of banks are obviously risky, as are all common shares. And I think you're right that banks are riskier than the S&P in general. But is their low historical P/E evidence of risk? Looking at data I got from Value Line on 299 companies of various industries for the ten year period ending with 2007, there's no correlation between the average annual P/E ratios of companies and the annual standard deviation of their stock price returns.

I know, I know... you don't necessarily equate 'risk' with 'standard deviation.' But in a thread some time back about Graham's views on diversification, you implied that P/E was positively correlated with risk - whatever that definition of risk may be.

I would think that P/E would more likely be correlated with expected growth rate? Or perhaps even market cap (inversely)? Others?

-Will

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Why do you consider banks risky? I have my reasons, per below, but I am interested in others'.

I think we agree that the low P/Es the market normally assigns banks is due to buyers perceiving banks as riskier. Yet using some perfectly reasonable measures for the last ten years or so, the risk is absent. (I have skimmed fundies on banks for awhile going back a decade, and your finding is what I would expect.) I think the next question is: Why do buyers perceive banks as risky?

My layperson's explanation to another layperson would suggest consideration of things like: (1) Citigroup when its share price fell by half from July to October of 1998; (2) the low ROA of banks? probably all sort of implications from this arise here that might justify lower P/Es; (3) awareness of the period c. 1991 when banks were being taken over, cutting dividends, and seeing their share prices declining significantly.

Let me stay away from more discussion on P/Es, since it gets into a discussion of value and growth; large and small caps; etc., ultimately some gray, subjective areas. For a few years now I have been seeking an explanation of why historically the S&P 500 P/E has averaged 15. Why is 15 "magic"? I have dug and dug and found nothing, though I do have my own hypothesis.

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In general, I don't consider banks risky per se (present credit troubles excepted). What I mean is that I consider common stocks to have volatile returns in general and that I consider them more volatile than those of lower returning securities like bonds. And judging from the KBW Banking Index, it looks like the returns of bank common stocks are more volatile than the S&P 500. So I agree with you that banks are probably riskier than the S&P in general.

But...

I actually don't agree with this. That was the point of my post that I obviously hid in the weeds. Somewhat counter-intuitively I actually expected stocks with higher volatility of returns to have higher P/E ratios. When I checked the data, I was surprised to find no correlation between volatility (standard deviation in this case) and P/E.

I agree, I think this is what led be to my first guess as I was equating 'growth' with 'high P/E' and 'growth' with 'more volatility', but this isn't necessarily true I suppose.

An excellent question. It may be no more magic than the average height of Montana women, i.e. it might just be a numerical artifact of our need to take averages. On the other hand, perhaps there is a discoverable reason...

-Will

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All a low P/E signals is that the market doesn't like the stock right now. There could be all sorts of reasons for this. While perceived risk is one, it could be that thinks the stock is:

1) Not sexy. 2) Not going to grow. 3) Likes something else better. 4) Doesn't understand it (I think this is a factor for banks, bank accounting is weird.)

-- Doug

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Well, as I tried to indicate in my last post, I thought different. My portfolio picks have been largely based on earnings growth and dividend stability over a decade, and banks did really well on these counts from about 1997-2006. (My focus has also been on diversifying for peace of mind, too, thank goodness.) Then again, with my stock purchases, I only buy if, among other questions, I can say at the time I will be comfortable holding the stock forever, through all sort of price changes. I almost do not care about price volatility over a ten- year period.

Either way, your finding above is interesting and suggests that buyers are in fact rational, en masse, when it comes to pricing bank stocks.

I wonder whether this is because P/E can vary so much from one stock to another. E.g. small, new company X may have highly variable earnings such that P/Es vary from 50 to 200, over the course of a year, with the stock price staying the same all the while. It is stuck with a high average P/E but no volatility over the year. Large, old company Y may have a range of P/Es from 10 to 20, also with the stock price staying the same. Both companies have the same volatility, but their average P/Es are very different.

I remain somewhat curious about it all because Jeremy Siegel's _Stocks for the Long Run_ puts much emphasis on growing one's portfolio by buying low P/E stocks with decent, reliable dividends, said dividends being reinvested. One could say the "old reliable stocks" offer the best chance for portfolio growth because one can buy so much more of them (they're cheap!) with the reinvested dividends. One gets that compounding kicking in massively.

People talk about "growth stocks," inviting all kind of gosh-awful, toxic, numerology-based "analyses." (The more math expertise, the greater the chance of seduction and being duped? This ought to be a modern rule of investing: stay away from whiz kids when seeking financial advice.) Maybe people should talk about Siegel's perfectly rational portfolio growth strategy instead.

My hypothesis on P/Es hovering around 15 is that those lucky few who financed new companies through IPOs way back when were happy if the company earnings in theory could pay them back after 15 years, which would be something like one-quarter of a lifetime. A trend was set.

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Historically bank stocks have been an outlier, on the low side, when it comes to P/E. To me this says a lot more than bank stocks are not the flavor of the day.

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The "right" trailing P/E hinges on earnings growth, or lack thereof (bankruptcy being an extreme form of "negative earnings growth").

A stock or sector could have a low P/E because of a low earnings growth rate. First, just intuitively...who would pay the same "P" for a dollar of earnings that will stay there at $1 forever, vs. a dollar that will be $1.50 within two years? Or, in finance jargon: highly simplified Gordon model where earnings are paid as dividends says

P/E = 1/(r-g) r is expected return demanded by investors g is growth rate assume competition for capital, r = constant no growth means lower P/E (it may not matter in the macro/model sense whether dividends are actually paid - so says Modigliani-Miller theorem)

A simplistic view (mine) walks into it by starting with a 4% inflation rate over the long run, adding a premium for "the inconvenience of not having your money for while, and perhaps not getting it back," plus another for investing in equities instead of nominal-return corporate bonds. But why that has on average landed at an earnings yield of around

6.7% (1/15) is anybody's guess! Also - even more fundamental - why is there inflation, and why 4%?

-Tad

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Do you think the following statement says the same?

"Historical differences between sector P/Es often hinge on historical sector differences in expected earnings growth."

If so, sure. Though at the moment, I give more credence to the theory that earnings by banks are more erratic, and so their stock price volatility is higher. Like the steel, auto, and oil industries, IIRC.

Why single digit inflation? Or why whatever number?

I bet the answers to this are very similar among economist minded folks.

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Yes, if by P/E you mean trailing P/E, and I think it's true whether it's a stock, sector, asset class, etc. "Trailing" is important though because there isn't the same justification for a high forward P/E - which arguably never makes sense. One oddity to me about P/E studies (whether of stock, sector, or asset class) is that overwhelmingly they focus on trailing P/Es rather than forward P/Es. But a new owner at t=0 is not really interested in the prior earnings, of which he'll receive no benefit. Instead the investment decision is (or should be) based entirely on anticipated earnings. But there isn't much good data about that, while it's easy to run studies based on current price and historical EPS. How would one determine historical forward P/Es? Only current IBES data about sell-side analyst earnings estimates is readily available, not historical (not from sources I'm aware of). And sell-side analyst earnings estimates are questionable source of the "E", anyway given the "cheerleader" aspect to them. You'd need to know the earnings estimate of everyone who was looking at the stock (including those who decided not to purchase).

Interestingly there are still quite a few theories about it, even though it's been one of the most studied and written-about topics in economics.

-Tad

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snipping much to meet guidelines and try to stay at least a little consistent with the subject line

Others and I were talking about how the banking sector's historical P/E differs from, say, the S&P historical average, hence my focus on the banking sector. Yes, I mean trailing P/E.

Aside: It might be more accurate to speak of how the banking sector's P/E historically lags that of the S&P 500 and other sectors, rather than attest that banking P/Es always average below 15. I have not had a chance to look at this fully.

Aside: If memory serves, Ben Graham was adamant about using only trailing P/Es. He was in the camp that felt, as you put it, forward P/Es never make sense. He has elaborated on why he feels this way, and I thought him persuasive.

I meant to query: Do you mean why is there single digit inflation? Or did you mean why does inflation set on X in such-and-such country at such-and-such time? Places like Israel had triple digit inflation from 1978 to at least the mid-1980s, for example. So I do not follow why you chose 4%.

I still feel many have a good intuitive answer to what may cause inflation. Either way, it is one of those economic topics that I think is particularly fraught with human psychology, anthropology, etc., so it's not a topic I care to explore here. Inflation and deflation happen. Six months ago I could buy a 2008 SUV for $30,000. Today I would pay $28,000 for the same vehicle. Why? Well one big reason and lots of smaller reasons.

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