How is a stock like an equity bond?

Warren Buffett described his philosophy of viewing stocks as ‘equity bonds’ in a 1977 Forbes magazine article and subsequently in a speech at Columbia Business School.  In her book, Warren Buffett and the Interpretation of Financial Statements, Mary Buffett attributes the concept to Buffett, which is interesting considering that the title of her book is a nod to an earlier work by the true father of that philosophy.

Much of Benjamin Graham’s classic tome The Intelligent Investor, which I am slogging through right now, centers on the problem of valuing stocks and bonds as complimentary investment vehicles.  Contrary to the conventional wisdom that young investors should invest most of their money in stocks and old investors should invest primarily in bonds, Graham suggests an ideal ratio of 25% bonds to 75% stocks when stocks are attractive, and the reverse when bonds are attractive.

Graham further argues that expected returns on individual stocks should be compared with prevailing bond rates by considering the historical returns of a stock and the likelihood that those returns will remain stable into the future.  To be honest, this philosophy sounded like a messy lot of work that was likely to return a steaming pile of boring stocks — public utilities, railroads and such.

In reality, it’s a quick way to whittle down the market into a manageable list of promising investments.  We begin with the Price to Earnings ratio, that great staple of every reliable stock screen.  Graham’s approach is somewhat different from the common practice of recommending a fixed P/E from which an investor should never deviate:

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings / price ratio — the reverse of the P/E ratio — at least as high as the current high-grade bond rate.  This would mean a P/E ratio no higher than 13.3 against a [presumably 10-year, corporate] AA bond yield of 7.5%.

In other words, before beginning your stock screen, the investor should divide 100 by today’s bond rate to derive a target P/E for your screen.  As of this writing, the average yield on the 10-year corporate AA bond was 5.05%, which means the average P/E of your portfolio should not exceed 20.  You can still consider stocks with P/E ratios above 20, but for every stock with a P/E of 30, you must invest an equal proportion in stocks with a P/E of 10.  Ideally, the investor will base the P/E on the current price divided by 3-year trailing earnings.  At present, setting a P/E ratio of 20 will eliminate  roughly 70% of the NYSE.

Now that the investor knows the present yield of his equity bond, he must determine the bond’s risk.  With a traditional bond, determining risk is easy.  Just go by those ever reliable (sic) Moody’s ratings.  To determine the risk of equity bonds, we must look to a basket of accounting ratios:

  • Annual Sales > $500 million (Graham’s original $100 million adjusted for inflation)
  • Current ratio > 2
  • LT debt / net current assets < 1
  • 10 years of earnings, of which the last three year’s earnings should average at least 30% more than the first 3 years.
  • 20 years of uninterrupted dividends
  • Price to book * P/E < 22.5

This is fundamental investing in a nutshell: turn the prevailing bond rates on their head to see what your P/E target should be.  After that, all you have to determine is earnings stability.  Buffett’s innovation, it seems, was to worry less about earnings stability, and more about growth.