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No Stock Is Forever

August 29, 2012

There is a sensible tendency among investors to believe that if we buy “good stocks” at “good prices” and hold them for a very long time, then it’s reasonable to expect that, over the long term, we’ll do very well. Thank you very much. We can expect to have a regular dividend as income or for re-investment in the same stock, and eventually have a respectable capital gain when we finally sell the stock or pass it on to our children and grandchildren (or the ex-wife, lawyers or doctors).

We have the confidence – and we have earned it – that our money is working for us and we’re not just working for it. Indeed. That is what we want, that our money is diversified and productively engaged in the workings of the economy and enterprise that we might not otherwise be a part of.

Some of the “Forever Stocks” that are currently and frequently being touted by salespersons are KO Coca Cola, GE General Electric, WPO The Washington Post Company, AXP American Express, V Visa, INTC Intel and DIS Walt Disney and, of course, they say, we’ll always need a defence industry, won’t we, and so, we should have some of BA Boeing, RTN Raytheon, LMT Lockheed Martin, NOC Northrop Grumman and GD General Dynamics. No doubt, we’ll always need “defence” just as we’ll always need something to drink, watch, switch on the lights, read, compute and borrow money on credit, and these companies are titans of those industries. But so are Proctor & Gamble, Johnson & Johnson, McDonald’s, Hewlett-Packard, Cisco, Chevron, Exxon and so many others that have grown large on our “needs” and one wonders what the distinction is between “Forever Stocks” and the rest which have all had their day in the sun, so to speak. Why not just buy them all and hold them “forever”?

It is not our intention to dispel dreams – indeed, it is our job to encourage them and hope to make them possible – and we hope that we have given due respect to everyone’s opinions but, having said that, we are ultimately responsible for weighing the evidence and making our own decisions and, at least, being able to explain them to ourselves without an appeal to some other authority.

If, then, we buy the entire portfolio of  recommended “Forever Stocks” today – say, one hundred shares of each of them – it will cost us $69,100 (and, in the interests of “reading”, we have replaced the Washington Post which currently costs $350 per share with the New York Times at $9.50 per share since both of these companies have similar problems and opportunities and the Washington Post is already down from $420 last year and still ten times as “expensive” as most of the other stocks respecting our rule of just buying one hundred shares of each of them without particular regard for the relative prices).

All of these companies, except the New York Times, currently pay a dividend of about 2 1/2% or $2,000 per year in total, and all but two (Boeing and General Dynamics are (N) and have been (N) all year) are currently (B) and, therefore, investment grade in our terms.  Please see our recent Post, (B)(N) AAPL Apple Computer Inc, August 2012, for an easy introduction to the (B)(N) technology and The Price of Risk, August 2012, for a more detailed technical explanation.

Had we (alas, the past tense) taken these twelve companies under consideration in early January and “worked” our usual (B)(N) methods, we would have bought only eight of them for $41,900 (Total) for an 18% return (plus dividends) instead of $60,600 then (Companies) and a 14% return (plus dividends) for the year-to-date.

Exhibit 1:  The Forever (Alleged) Portfolio – (B)(N) There And Done That

(Pleas Click on the chart to make it larger if required.)

In the chart of accounts (Exhibit 1), Cash In and Cash Out are due to sales and purchases of stocks. The Portfolio line is the value of the stock portfolio (in $00’s) and the Total is the sum of the Portfolio  value and the Cash account (which could be negative if we use the margin account or borrow money in order to buy stocks, either of which are discretionary).

But what of the future? Is it not odd that the “Forever Stocks” that we are supposed to buy now according to the “Forever Stocks” have almost all had double-digit gains so far this year and what should we expect in the future and who will guarantee it?

Exhibit 2:  Forever Double-Digits

The coloured lines in Exhibit 2 show which companies and when they were included in a Perpetual Bond (B) based on just these twelve stocks. All the others are (N), that is, the stock price is less than the risk price at that time and the stock is trading in the “volatility zone” that is dominated by investor uncertainty or some other anxiety that we really can’t know because there are thousands of investors who are daily buying and selling these stocks to each other. Obviously, buyers have different motivations from sellers and we should not expect a significant change in the stock price until there is a widespread alignment of their differing but complementary interests.

The solution is simple. We only buy the ten companies marked (B) and the portfolio cost is $55,100 (Portfolio, August 2012) instead of $61,900 (Companies, August), leaving out Boeing and General Dynamics, for now and for no other reason than that they are (N) and not (B). But, we can make an effort to understand that rule by studying the two Charts below (Exhibit 3 and 4).

Exhibit 3: (B)(N) BA Boeing Company 2008-2012

One wonders, of course, why we would buy all the “high priced” companies and not the still  “low priced” BA Boeing Company or GD General Dynamics at the present time. The Price Chart (Exhibit 3) for Boeing, for example, shows that we have owned Boeing in the past between $40 in early 2009 and $75 in mid-year 2011 nearly three years later, but not thereafter and not now. The daily high and low stock prices for Boeing are shown by the Dark Line and the Grey zone below it; the Risk Price (SF) is the Black Line and is a step-function and the Stock Prices (SP) at which we “bought” and “sold” Boeing are shown by the Red Line and is also a step-function with values that are typically enforced by a “protective put”. For more information on the Chart elements, please see our recent Post, (B)(N) AAPL Apple Computer Inc, August 2012, and for the “protective put”, The Wall Street Put, August, 2012.

Neither “buying” nor “selling” is, in general but not always, as simple as just “buying” and “selling” the stock. Because the Risk Price is an effective “floor” when the stock is trading in (B) and the stock price is above the risk price when we own it, we “buy” and “sell” using the “protective put” either to protect the capital or lock in the demonstrated prices. In practice, because of the “protective put” on our long position, we need sell only when we want to and are indifferent to the daily stock price volatility. The case of (N) is different because there is no floor and one might consider that all stock prices begin and end at zero (Goetze 2009). Please see Stock Prices Are The New Pink, June 2012.

Exhibit 4: (B)(N) GD General Dynamics Corporation 2008-2012

One sees from Exhibit 4 that we have also owned GD General Dynamics Corporation between $40 and $70 in 2009 through early 2010 (Red Line above the Black Line) and again, briefly, at $65 in late 2010, but otherwise not. The “jump” in the Risk Price (SF) from $62 to $93 is not an error but due to a significant drop in the “balance sheet value of its enterprise” that had not yet been reflected by a significant drop in the stock price which is now trading in the “volatility zone” (N).

The “Risk Price” (SF) is not, however, some deus ex machina but the essential term of an economic utility function, U = SP – SF,  of von Neumann-Morgenstern type (John Von Neumann and Oskar Morgenstern  (1944), The Theory of Games and Economic Behavior, Princeton University Press, 1953) and we have shown (Goetze 2009) that it can be implemented by a risk adjusted price (SF) of Sharpe-Markowitz type (William F. Sharpe, Capital Asset Prices with and without negative holdings, The Nobel Foundation, 1990 and Harry M. Markowitz, Portfolio Selection, Journal of Finance, 1952).

In short, stock prices above the price of risk are an economic free good and shouldn’t exist if markets were efficient, frictionless and equilibrated. But they do and, knowing that, we can make money on the heat in perpetuity, which is better than “forever” because we can get our money now.

For more information, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used.

These data may be obtained from us for free by simply sending us an email request at RiskWerk@gmail.com and consist of the three data files S&P 500 NYSE (B)(N), S&P 500 NYSE (B)(N) Risk Price and S&P 500 NYSE (B)(N) Stock Price, or for any of the major North American markets,  in a machine readable format.

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)”, “(N)” and N*.

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