(B)(N) The 15% Hurdle Rate

Where is that 15%?

Drama. Your pension plan is not going to return 15% on your money this year and it will never return that much for two years in a row. But why not? And why not every year? And what does that have to do with lightning?

For example, 15% per year without capital risk is small change in the (B)-Class Portfolio and we regard 15% per year as a failure (please see our Posts and the examples below) as long as there is an active market somewhere – and the more active it is, the better – but getting it in the old way of “no risk/no reward”, they say, turns ordinary schooled men and women with a good story and a care for your wealth into legends if they don’t lose all of your money first.

Figure 1: Distribution of Portfolio Returns – World Trade

The market’s fear of volatility (called “risk”) has a price to be paid for the “risk defense” of investment returns for the “long-run”, they say, in its risk-galvanized balanced, global, income, emerging market, and so forth funds and ETFs of which there are thousands and even hundreds crafted by our betters at every bank.

To estimate that cost in foregone returns, if any, we mined our World Trade Portfolio for all of those companies for which the investors (not the companies which are just the “underlying” for their stocks) have returned at least 15% in every twelve month interval for the last five years starting in any of those sixty months; please see the chart in Figure 1 above for more information on the distribution of those returns aggregated in the World Trade Portfolio by market value.

Say goodbye to the “Risk/Reward Equation”

But, alas, even though investors tend to pay [P/E] 20×, 30×, and more for earnings without surprise, we didn’t find any such companies.

That is, there is no company in our World Trade Portfolio of 1900 companies currently worth $50 trillion which the investors bid-up by 15% or more every twelve months no matter when we bought it in the last five years although there was one at 11.8% (Northrop Grumman Corporation) and then two more at 11.3% (CCL Industries Incorporated and Domino’s Pizza Group PLC) and then no more until 9% (Reynolds American Incorporated which is now owned by British American Tobacco with a premium of 30% per share over last year’s prices).

And the largest portfolio that we can build at only a 5% hurdle rate for the companies in it (as above) which is just the market yield on many commonly held stocks with [P/E] 20× or less earnings, has only six companies in it worth $240 billion today.

Moreover, that portfolio can’t be reached by volatility management or diversification because it has an average return of 32% per year (please see below) and a standard deviation of 9% in a range of 16% to 70% which can occur in any month of any year.

In order to get 15% per year on average, we need to work with a portfolio that has 500 companies in it worth $23 trillion today and with a negative hurdle rate of (-20%) and a range of returns between 1% and 30% which sounds familiar on the day-to-day although the (B)-Class Portfolio in those companies will guarantee at least 15% per year every year which can be taken into an income without corrupting the portfolio.

In other words, the price of volatility defense is enormous because it’s blind to what we want – we want 100% capital safety, 100% liquidity, and a hopeful but not necessarily guaranteed return above the rate of inflation or it isn’t an investment – and the demonstrated worth of its harvest is zip but for six companies that pass the test (as above) and leave your balanced global income emerging market fund to rely on them (if you could reach them) and all of the rest of them too to not, somehow, lose your money this year or next.

The Cost of Risk

However, those six companies have some nice properties in this market of the fearful and ever anxious for their next loss; for one thing, just buying and holding them for five years according to their market capitalization in 2012 ($44 billion) has increased our net worth by +415% and an average of 32% per year and, as a portfolio, its year-over-year value increased by no less than 16% no matter when we bought it.

Where’s my money?

And by just doing what everybody does and spending the same amount of money on each of them in 2012, we have increased our net worth by +465% and an average of 35% per year and that result is not improved by the (B)-Class Portfolio which is, however, 100% capital safe no matter what the market does in case next year is not like any of the last sixty “years” for these companies.

And we’re already good for +30% this year even while your pension plan is struggling to feed its pensioners for the next forty years or so, they say, and probably won’t get the job done unless you give them more of your money this year.

To help them out and reduce your taxes, we’ve also done “The 0% Plan” with a 0% hurdle rate (as above) so that if your portfolio manager runs this plan, they are unlikely to ever have to report a loss to you on any company which they bought for you with your money but they might still have to find some way to diversify away your profits and reduce the volatility by shopping in Europe, South America, or emerging markets because almost all of those companies are based in the US and Canada.

“The 0% Plan” has forty-five companies in it with a current market value of $2.2 trillion which is up from $600 billion in 2012 and up +28% this year but it too falls far short of our goal (15%) with an average return of 25% a year (way too much money for you) and a volatility of only 7% in a range of 8% to 40% per year no matter when we bought it; please see Exhibit 1 and 2 below for more details (and click on them and again to make them larger as required).

The 5% Plan

Exhibit 1: The 5% Plan

The 0% Plan

Exhibit 2: The 0% Plan

The Real Cost of Risk

A typical pension plan that manages, say, $100 billion of assets and returns only an average of 10% per year (which happens to be quite rare and averages of 4% are more common and still hard for them to obtain) when it could have returned an average of 15% or better or, as in our case, 30% per year in the (B)-Class Portfolio or we’re slipping if we’re not getting 7% per quarter and we need to fix that, is costing the pensioners $20 billion/24×365 = $2,283 per hour in forgone income without affecting the capital at all.

Nickels In Front Of Bulldozers

In other words, said pension plan is writing-off the total income of at least 400,000 of its current workers earning an average of $50,000 a year and 800,000 of its current pensioners at half that amount in order to reduce “volatility” in their search for an effectively unknown return.

Another way to look at that is that it’s writing-off 4 million workers who are paying 10% of their income every year to support said pension plan.

The next risk equation that we write is that your money is flowing into the world stock markets at the rate of about 9% per year but the revenues and earnings of the companies can’t grow much faster than the rate of growth of the world GDP which is about 3% per year; please see Exhibit 3 below for which hurdles will get the most respect next year.

Exhibit 3: The Real Cost of Risk

For more information on real “risk management” in modern times and additional references to the theory and how to read the charts and tables, please see our Post, The RiskWerk Company Glossary and “(P&I) Dividend Risk and Dividend Yield“, and our recent Posts “(P&I) The Profit Box” and “(P&I) The Process – In The Beginning“; and we’ve also profiled hundreds of companies in these Posts and the Search Box (upper right) might help you to find what you’re looking for, such as “(B)(N) TLM Talisman Energy Incorporated” or “(B)(N) ATHN AthenaHealth Incorporated” or “(B)(N) PETM PetSmart Incorporated“, to name just a few.

And for more applications of these concepts please see our Posts which rely on the Theory of the Firm developed by the author (Goetze 2006) which calibrates The Process to the units of the balance sheet and demonstrates the price of risk as the solution to a Nash Equilibrium between “risk-seeking” and “risk-averse” investors within the demonstrated societal norms of risk aversion and bargaining practice. And for more on The Process, please see our Posts The Food Chain and The Process End-Of-Process.

And for more on what risk averse investing has done for us this year, please see our recent Posts on “(P&I) The Easy (EC) Theory of the Capital Markets” or “(B)(N) The Easy (EC) Theory of the S&P 500“, and the past, The S&P TSX “Hangdog” Market or The Wall Street Put or specialty markets such as The Dow Transports & Utilities or (B)(N) The Woods Are Burning, or for the real class action, La Dolce Vita – Let’s Do Prada! and It’s For You, Dear on the smartphone business.

And for more stocks at high prices, The World’s Most Talked About Stocks or Earnings Don’t Matter – NASDAQ 100. And for more on what’s Working in America, Big Oil, Shopping in America or Banking in America, to name just a few.

Postscript

We are The RiskWerk Company and care not a jot for mutual funds, hedge funds, “alternative investments”, the “risk/reward equation” and every other unprovable artifact of investment lore. We have just one product

The Perpetual Bond™
Alpha-smart with 100% Capital Safety and 100% Liquidity
Guaranteed
With No Fees and No Loads on Capital

For more information on RiskWerk, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used. Related data may be obtained from us for free in a machine readable format by request to RiskWerk@gmail.com.

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®™, The Medina Bond®™, The Barometer®™, the Free Market Yield®™ and Extreme Economics®™ 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*.