Why Stocks?

Having stated my defense for the activity of investing, and the history leading to my involvement, I need to answer the question, "Why stocks?"

I will not say that investing in stocks is the only or best way to practice capitalism. There are many people who prefer to invest in other types of privately held enterprises such as rental real estate, or other entrepreneurial businesses. Such investments may seem to provide larger gains. Investment in real estate, prior to the financial collapse of 2006-2008, actually appeared to be a superior type of investment. There are, however, great risks involved; it should be remembered that the higher the rate of return, the greater the risk associated with the investment.

While investing in rental real estate may seem to produce a high rate of return, all of the factors that bear on the investment need to be considered. In appraising rental property one of the critical errors observed has been the underdevelopment of replacement reserves, because small landlords rarely anticipate depreciation of their property. (After all, haven't they been told repeatedly that real estate always appreciates, and never goes down in value?) Over an anticipated 30 year life of a property, the roof, furnace, and windows can be expected to require replacement at least once in order for the building to hold its value, and water heaters are notorious for their less-than-10-years lifespans. Carpet, paint, landscaping -- these are all robbers of profit.

Vacancy rates are rarely studied by budding landlords, yet the lack of cash flow created by a two-month vacancy has resulted in many a foreclosure. A landlord may buy a house to rent for $100,000 with $20,000 down, and find that over 30 years, at a 5% interest rate, he has paid $155,000 in principal and interest to the bank, plus taxes and insurance and maintenance costs. If he anticipates $800/month for 30 years ($288,000 gross rent) to be offset by the loan ($155,000) plus taxes ($2000/year) plus maintenance ($1000/year) and sells the house at the end of 30 years for near his original purchase price (a not uncommon thing in many Mid-western towns), he may find that his $20,000 would net about $143,000.

This would require that the landlord pay out about $680/month from the gross rent, and assumes no vacancies -- an ideal situation. In reality, there would be some months when due to vacancies and repairs the landlord would be paying out of pocket. It also assumes that the landlord will be directly managing the property himself. If a management company is needed, it can be expected to demand about 10% of the annual rent as its fee, which would reduce the net by just under $29,000, to about $114,000, and the impact of a typical 5% vacancy rate would bring the net to about $100,000.

That is not a bad return on a $20,000 investment over 30 years -- roughly 17% annually, and the landlord is providing housing for his tenants. However, there are still risks involved -- unplanned assessments or repairs, changes in the neighborhood which might affect appeal and rentability, and the possibility that property values might decline near the time of final disposition of the property. There is also the very real problem that real estate investment is not very liquid, and having to sell real estate under compulsion can be disastrous.

To be fair, there is also the possibility of a significant rise in real estate prices; that has been the dream of many a real property investor. There is also the possibility that market rents could increase in such a way that the monthly cash flow would make a very comfortable addition to ordinary income. Still, the percentage of would-be landlords who actually make a net profit on their residential rental properties is in reality very small. To be a successful small-scale landlord requires the ability to repair and maintain dwellings (or the willingness to hire someone else to do so) and excellent people skills in not only interviewing and initializing the rental agreements but also dealing with less-than-ideal or deadbeat tenants (or, again, the willingness to pay someone to do that for you).

Few people have the ability to successfully manage residential rentals, and to subcontract the necessary management to others requires a different set of skills possessed by an even smaller population of investors.

What then of other investment vehicles? Since the post-WW2 recovery, many mutual funds have track records over the lifetime of the fund returning about 12% annually. A $20,000 one-time investment left to grow at 12% would yield about $720,000 at the end of thirty years. I wish that had been impressed in my head back in the days when I was single and was making more money than my Dad.

In fact, a fund returning only 10% on the same size initial investment would yield about $400,000 at the end of 30 years, and would be throwing off dividends of over $10,000 per year -- a very nice supplement to Social Security indeed -- without even touching the principal. Or having to deal with tenants!

In contrast, the $20,000, if placed in stocks paying 4% annual dividends reinvested quarterly, would yield a net of about $66,000, assuming no stock splits over a 30 year period, and again, assuming no increase in the share value. The dividends on that sum at 4% would be only $2600 per year. Why, then, would I choose stocks over real estate or mutual funds as an investment vehicle?

I mentioned in a previous post the fact that fund managers, whether for regular or tax-deferred accounts, charge for their services. Indeed, the managers of well managed funds deserve every bit of the fee they charge. However, aside from the ability to vote for the directors of the fund at the annual meeting, the shareholder has no input into the decisions made regarding the investments. If you look at the composition of most of the best performing growth-and-income funds, the largest holdings will be in financials (banks and insurance companies) and companies which produce beverages (the adult kind) and tobacco.

I have an aversion to supporting either. That may make me a hypocrite with respect to the adult beverages, since I buy and consume them, but I don't feel right about producing and selling them to the general public. In the wrong hands, alcohol and tobacco can be (notice -- I am avoiding total condemnation of them) destructive to the Project Earth workforce. I prefer to err on the side of caution. Likewise, I prefer to avoid the financials because of their role in enslaving that same workforce.

So why stocks? There are several practical reasons, one being that a shareholder does not have to manage the company directly. He doesn't actively participate in the business, and is not legally liable for the company's actions. Another is the liquidity of the investment -- not only can he buy the interest in the business in small chunks, but he can also dispose of it in the same way. A third reason is that the investment can be spread over several sectors of the general economy -- a means of keeping all your eggs out of the same basket.

There are also altruistic reasons, the reasons which are most important from the standpoint of stewardship of God's Project Earth. As a shareholder in a company, you are an owner. You provide work for the employees of your company, since the capital you have injected helps maintain the cash flow. As an owner you also have the ability to influence the moral direction the company takes. Granted, your influence is only proportional to your ownership, but it can still be brought to bear.

Finally, there are the fun reasons. When you invest in a business, you tend to try to find out how it works. You develop an interest in the factors that drive that trade. You find yourself examining the issues that affect the workers you employ. Your horizons broaden; my portfolio makes me an energy baron, a food supplier, a telecommunications provider, and a shipping magnate, to name a few sectors. My Suezmax tankers are bigger than your pleasureboat, are they not?

I hope that no one reading this takes these ideas as points of dogma. I see nothing wrong with investing in real estate; it just isn't "my bag". There is nothing absolutely wrong with mutual funds; I simply prefer to control a bit more closely what my money is doing (and I do own shares in a fund which carries between 3-5% of its investments in financials). I just have a preference for industrial holdings from the stand point that making useful things seems to me to be a good way to exercise dominion over the Earth.

How then, do I chose which companies to invest in? We will look at that next.