The Perpetual Bond (B)

The Perpetual Bond™ (B)™ is a replication technology that is a corollary of The Separation Theorem (Goetze 2009):

Any market of the common equities, free-market or not, partitions into a portfolio of stocks (B) that has the properties of a “risk-free” bond and a portfolio of stocks (N) which is the exact complement of (B) and that has the properties of  an “equity portfolio”.

The theorem (and it is a theorem in mathematics as well as economics) is correct even if the “market” consists of just one company and the underlying theory (the theory of the firm and the ‘N/B/W’-financing model) can also be applied in underwriting and investment banking in which “publicly listed stock prices” are simply not available or not yet available as in the pre-IPO (Initial Purchase Offer) pricing of new stocks which are generally less “liquid” than those of the secondary or common equity markets.

“Risk” in this context, however, is the possibility that if we make this investment, buy this stock, so to speak, then we might not get our money back and  we might not get a hopeful return above the rate of inflation.

In other words, the concept and definition of “risk” has very little to do with “volatility risk” which is the daily ups and downs of stock prices and investor perceptions or anxieties. The portfolio (B) “has the properties of a risk-free bond” means exactly that we will get our money back (100% Capital Safety and 100% Liquidity) and, although it is not guaranteed, there is a reasonable expectation that the positive return will exceed the rate of inflation, which, in general, is no more than we can expect of a government bond or high-grade corporate bond.

For example, if we are persuaded to buy a discounted government bond, say a T-bill, for $95 today and a “certain” return of $100 in six months time, then our expectation is that inflation will not exceed 5% in the next six months but we cannot guarantee that it will not. That is our risk, that the “certain” return of $100 will not be “worth” what we paid for it. The “risk” in equities investing, however, is generally more complicated because there are neither capital nor return guarantees of any kind.

The Contra Portfolio™ (N)™ has the “properties of an equity portfolio” and the reasonably expected return is zero or less, a result that will surprise most equity investors although it should be obvious that if the stock is for sale then the qualified buyers and sellers must also have differing needs and expectations for the current and future returns of the stock.

An example of The Perpetual Bond is the portfolio described in a previous Letter (Dow Jones Industrials – (B)(N) There and Done That, June 2012).

Exhibit 1: The Perpetual Bond (B) Dow Jones Industrial Companies 2009-2011

The dark, solid, line is the total value of the portfolio at the end and during each quarter between early 2009 and the end of 2011.  The light bars are the corresponding values of the equity part of the portfolio and the darker bars are the values of the cash account, monies that we have earned in capital gains subsequent to the original investment of $1,153,000 at the end of 2008 and early 2009. What we bought and held (B) is summarized in the following table which is explained more fully in our previous Letter:

Exhibit 2: The Perpetual Bond (B) and The Contra Portfolio (N) 2009-2011

One could ponder this result for a long time because it is quite rich in both technology and in what it says about equity investing that is very different from the common “understanding” of most equity investors today.

Moreover, we have obtained similar results in every major market in North America with essential differences only in the resultant returns. For example, for the three years from early 2009 through 2011,

In contrast, the behaviour of the “equity portfolio” which we have called The Contra Portfolio (N) is quite different and that behaviour is predicted, that is, required by the underlying theory if in fact the theory is confirmed by the actual practice of investors.

Exhibit 3: The Contra Portfolio (N) Dow Jones Industrial Companies 2009-2011

Whereas simply buying and holding all the thirty companies of the Dow Jones Industrial Companies provided an aggregate return of 12% per year, or $1,605,000 exclusive of dividends, the Contra Portfolio (N) returned next to nothing.

In effect, the Contra Portfolio (N) buys and holds what we sell or avoid, and sells what we buy (in (B)) and one also notes that the Contra Portfolio tends to “buy at low prices” when there has been a significant overall decline in the market (compare the equities account and the cash account with the Dow Jones Industrials line) and “sell at higher prices”  – that is, when there is an (N)- to (B)- transition which is signalled by a prevailing stock price that exceeds the risk price. Such investors would, one would expect, do better if they didn’t sell what we’re buying.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  “price of risk”, “risk price”, and the symbols “(B)” and “(N)”.