Are You An Owner or Lender? | Brandon Averill, Justin Dyer | AWM Insights #95
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Episode Summary
To understand investing, you must start with ownership and lending. You can use your money to either buy ownership or lend it to borrowers. Investors are either owners or lenders, anything else is a speculator.
Ownership
Participation in profits, growth, cash flow. You own the future of the business for good or bad.
A stock, mutual fund, or ETF is your claim to the assets minus liabilities, but most importantly the stream of future profits.
Lending
Loaning out money in exchange for fixed payments and eventually a return of your initial investment.
Individual bonds, bond funds, or bond ETFs do not entitle you to the growth of a company. But in exchange, if the company goes out of business, you have a higher claim on the company’s assets than stockholders (ownership).
Episode Highlights
(1:05) The very first principle of investing.
(1:53) Ownership versus lending.
(2:25) Ownership is a claim to the company’s profits. And that means risk if the business does poorly.
(3:30) Your equity in the business is assets minus liabilities and the future profits or cash flows from the business.
(4:05) Companies may not be profitable now but have the potential for large future profits which will make the company valuable.
(4:42) Real estate equity is the same math as equity in a company.
(5:55) Rental real estate and the future income it provides is a great example.
(6:15) Discounted Cash Flow explained. This is how you value an asset.
(7:20) Valuation is the basic principle of financial markets. It’s the same process no matter what asset you choose to value.
(8:08) When it comes to being an owner or lender, you can do it in the public market or private market. The biggest differences between the two is efficiency of information and volume of transactions.
(9:08) Private markets have illiquidity issues and slower transaction time to complete a purchase or sale.
(9:45) If you own the shares in a public company and they release reports about their expected future cash flows increasing. The value of your ownership has gone up.
(11:49) Lending is called fixed income and/or bonds in the industry.
(12:40) You lend your money in exchange for interest and your initial investment is returned at the time period.
(13:00) Lenders have a higher claim than owners in the event of bankruptcy so it is less risky to be an owner. But you also are not entitled to profits if the company does extremely well.
(13:57) Public Debt vs Private Debt
(14:30) A good example is mortgage lenders and the specialization of lenders.
(16:50) A good example of lending is Microsoft selling bonds to investors. Because Microsoft is so large and with a strong balance sheet. They are able to get a very low interest rate which the market sets.
(17:30) Tax treatment is a huge area where lending versus ownership is much different. Ordinary income versus capital gains respectively.
(18:30) What about gold, art, and crypto?
(19:11) It’s not an investment if it doesn’t fall into either ownership of a business or lending. It is speculation
(19:11) Gold, art, bitcoin are all speculative because there are no future earnings or cash flow to expect. You only hope to sell at a higher price.
(19:11) Crypto is not ownership nor lending. Your only return will come from selling at higher price (or lower).
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+ Read the Transcript
Brandon Averill (00:01):
Hey, Justin. Welcome back. Excited to talk a little investments today. I know we got into it a little bit last week, but we're going to hit on how do we actually go about this whole investing thing. So I'm excited. Let's jump right in, buddy.
Justin Dyer (00:18):
Jump right into it. And we're going to build on this and I think keep it relatively basic. Probably tease out some topics for future deep dives and future full episodes. But I mean, this is a topic that I love. I mean, I went down the crazy CFA rabbit hole, I've kind of studied this type of stuff my whole life and it's interesting. Investments, broadly speaking are just really, really fascinating. I know we use that term quite a bit, but they're fascinating. It's a fascinating topic. And what we're getting into today is starting to dive into the nitty gritty of actually how you invest, what are the different ways in which you can invest money.
Justin Dyer (01:03):
And really starting at the first principle, as they say, which is always a great place to kind of start understanding a topic, let's go back to the first principles. What are we talking about? We're talking about either ownership of something or lending money to someone, some entity, something concrete, right? And so that's as simple as it is, all the stuff we hear about and the noise, and the complexities, and there are complexities in financial markets and investing, but they're all derivatives from those two simple facts, simple structures, let's call it. And it's important to understand the complexities, certainly, but again, let's go back to this first principle concept of ownership versus lending. What is what, what are the different ways in which you can take ownership, what are the different ways you can lend, what are the different entities or people you can lend to? So on and so forth, so that's the broad topic here today. And Brandon, you want to jump in to the first one?
Brandon Averill (02:11):
Yeah, I think that's great. So I think future episodes, we'll get into specifically how do you do these things, but yeah, let's start with ownership. At the end of the day, what are we getting with ownership, when we buy something, and we actually own it, we're going to participate in the profits. Well, hopefully there's profits, right? We're going to participate in the company growing and producing cash flow, and we get a share of that cash flow. So we actually are a, "Business owner," let's say in that case, but on the flip side too, if the business doesn't do well, our entire capital is at risk, right?
Brandon Averill (02:57):
And so I think that's a good way that people don't necessarily realize, but when you're investing in, let's call it a stock on the stock exchange, or even if you're buying an ETF, you're buying a basket of companies, what you're really doing there, is you're claiming a portion of those business assets. So what's on their balance sheet, what are the things that the business actually owns, you're going to subtract out what they actually owe, and there's something called equity. So you actually own the positive, hopefully positive equity, in that business, but then also you own a stream of future cash flows. So if you have a business that is expected to produce a certain amount of profits in the future, you own a percentage of those profits in the future.
Brandon Averill (03:51):
If it happens to be one of these big companies that doesn't really care about profits right now, and is more growth oriented, you might be more comfortable or you're going to understand that you're recognizing you have a share of the losses because you believe that that business is going to grow in value and create enterprise value. So I'm talking about company growth, but this could extend even to real estate. So there is a component there where you actually own real estate. Maybe Justin, you can kind of correlate from what I just described on the business side, actually owning the business up and down to the ownership side, let's say in real estate.
Justin Dyer (04:38):
Yeah. And the math is essentially the same thing. Let's use a personal residence as probably the most relatable example here, where most commonly someone goes to buy a house. They generally don't pay cash for that house, or they put a percentage of cash down. Maybe it's 30%, maybe it's 50%, whatever it is. They then borrow money, and so we're kind of getting into the lending piece of it as well, which we'll touch on obviously in greater detail, but then they borrow money from an entity, usually a bank to make up the difference. So then your personal real estate balance sheet in that situation is made up of the asset of the house, which let's just say it's a million bucks. And then a loan, let's say it's a half a million dollars, is deducted from that asset and you're left with equity of $500,000.
Justin Dyer (05:28):
The same math as Brandon, you just outlined with respect to it, a company where the ownership is essentially the net assets or net equity that's left over, that represents your ownership interest. Now, to tease out potentially a future topic that you hit on where with a company. And if it's a piece of real estate that's an investible piece of real estate, a rental real estate, let's call it, that you're then going to lease out to somebody and you're going to get cash from that. The cash flow that you, "Own," expanded into the future or extrapolated into the future, projected into the future, however you want to say that, is how you value you that asset, or how the market values that asset.
Justin Dyer (06:19):
The market says, "Okay, I expect company X to have profits of," let's say, "10% profit margins going forward. What does that actually mean in a dollar perspective?" And then there's a simple formula you do to say, "Okay, if that company has 10% profit margins for this year, next year, the year for... et cetera, all the way into the future," because a company arguably is at least generally always considered to be a perpetual entity. I mean, there's no, "Death of a company," no set death of a company certainly. There's bankruptcy and companies do go under, but you project what your share of those cash flows are, profits or otherwise, whatever you're using to project here and you do a calculation, bring it back to the present day and that's a simple valuation formula.
Justin Dyer (07:10):
Again, we're kind of really trying to start with basic principles here. And that is still in place and really the underpinning of how financial markets work, especially on the equity side, very similar type of formula with respect to lending and bonds, which we'll touch on. And it's a similar type formula when you're trying to value a piece of real estate. You take the cash you're expected, in that case you have to pay off your debt and then you take what's left over and then kind of by back into to the value of your real estate.
Justin Dyer (07:41):
Now, there are assumptions that go into some of those formulas, like how much is cashflow and profitability going to grow over time. And it's not all facts, if you will, there's an element of subjectivity that goes into that valuation formula. But those are the building blocks of financial markets and valuing assets. And then taking it a step further, and we talked about this a lot, we have private assets and we have public assets. The basic building blocks, the basic tenants that we're talking about apply in both places. Really the main difference between the public markets and the private markets is efficiency of information. The efficiency in which information gets reflected into the prices, and as a related point to that is the volume at which assets are traded back and forth, or the volume at which assets trade hands in the public markets.
Justin Dyer (08:40):
I mean, I'm sure you guys have seen, you go to whatever it is, CMBC and right at the closing bell, you'll see how many shares were traded each and every day. And it's a mindbogglingly large number, how many shares trade on a daily basis within the public markets. A lot of things happen in the private markets on a daily basis, but you can't necessarily make the same translation over to the private markets. Things don't happen as fast, there's an illiquidity, that's a common term to use, illiquidity nature to the private markets that brings about challenges if you're not prepared to deal with them. But if you are prepared, you have the right financial structure, it actually can provide a great benefit.
Brandon Averill (09:24):
Yeah. And I think one thing to point to, is like right now what's happening, we just got reports that there have been strong earnings across the US public equity, public stock, public ownership market, those are all synonymous. And so what happens is that if you own a share of the cash flows in a company or a broad index of US companies when reports come out like this, will the market quickly adjust to say, "Well, I expected to receive," let's say, "A hundred or dollars of cash next year." And now, what it's looking like is the estimates being provided by the public companies. They actually have to say what they expect, are that now, your hundred dollar expectation you should expect to receive $110. Now the value of your investment is going to go up. And so I think that information in the public markets, super efficient, they have to report on it.
Brandon Averill (10:21):
Everybody gets access to that information at the same time, whereas the private markets that is not done. So that's where you see a little bit different, but that's also how your value of your ownership stake can move. Now, same to the downside, if you were expecting a hundred dollars of earnings next year, that's your share. And the company comes out and says, "Well, actually we were talking with a private equity investor this morning and there's a dry ice shortage apparently in the US right now." And so some of these companies that deliver fresh foods, meal kits, et cetera, they're under pressure for a business risk that most of us probably wouldn't even have thought about, but they can't get dry ice to actually keep the stuff cold when they're getting it to your house, or it's a lot more expensive.
Brandon Averill (11:13):
Things like that may happen and that's going to actually decrease. Okay now, I can't expect a hundred dollars, I can only expect 90. Now my value of my ownership in this company has gone down because of this business factor. So I think that's another thing that's happening right now and I think very tangible ways of what you can expect there. And we'll get into, in future sessions certainly, what should you expect? I think that's a big part of this whole thing. But I want to make sure we hit on lending too, because I think this is something people get really confused about, about what's a bond. Bonds are safe, right? Well, I think our industry does a terrible job at just throwing out this blanket statement. I mean, you've got bonds that are just as risky as the ownership side and it's about being compensated for that risk, we'll dive into.
Brandon Averill (12:09):
But very first principles, Justin, we hit on a little bit with a mortgage, but lending and a bond or fixed income, again, all synonymous. Those are terms that we use in the industry, but really at the end of the day, it's lending. So rather than most people are familiar with being a borrower, what you're actually doing is you're taking your money and you're lending it. You're going to give it to Google, or you're going to give it to Facebook, or you're going to give it to the US government. And what's happening there, is they're promising to pay you back your money and they're promising to pay you an interest payment. And so inherently that's a little bit safer, right? If I'm lending money to Google, it's less risky than me buying ownership of Google. Now, the reason why it's less risky is the outcomes are much tighter, most likely.
Brandon Averill (13:01):
So if Google underperforms earnings and my ownership stake drops in value, if I'm a lender to Google, what I'm really evaluating is, can they pay me back? And unless things have gone really poorly, the odds are that they're probably still paying me back, and I have a certain level of security as well. So if the company goes bankrupt and they have to get rid of all the assets, I'm the first one as the bond holder, the lender to get paid back while the equity, the ownership people just kind of have to sit and wait and see how much actually gets paid out. So there's some safety there, but maybe talk a little bit, Justin, what's the difference between public and private lending, because there's a public market and then there's also this private market as well.
Justin Dyer (13:54):
Yeah. And it's a similar, I would say a similar dynamic. Again, we're talking kind of broad first principles here, where within the private market, there's potentially informational asymmetry from a lender perspective as well in addition to what we talked about on the equity side. At the same point too, there's some structural things from a private debt market standpoint as well, where a lot of lending is institutionalized with the big banks, meaning when you go, using the mortgage, again, I think that's a really good relatable example. When you go to get a mortgage, chances are you're going to go to Wells Fargo or one of the big banks. Not always the case, if there's some unique circumstances, et cetera, et cetera, you might have to find a lender that really understands your specific situation and they're out there and that definitely does happen. But again, we're talking in first principles generalities here where the structural side of the lending market generally resides with large institutions, big banks, Wall Street firms, et cetera, et cetera.
Justin Dyer (15:02):
And they then develop an expertise in lending to certain companies as well. So they're comfortable lending to certain borrowers for home purchases who are acquiring a mortgage from them, they want certain credit scores, certain income amounts, et cetera, et cetera, same thing from a company side. So they only want to lend to companies with over a hundred million dollars of revenue and that that space is really institutionalized and kind of crowded with these large institutions. Where private debt comes into play is kind of in this quote unquote... I mean, it can be many forms, but using this structural asymmetry as an example, in the middle market where there's not as many players. There aren't these big banks that have huge balance sheets, there's the ability for smaller institutions.
Justin Dyer (15:56):
I mean, we're still talking large investors here to come in and do underwriting and understand a company that may have 50 million of revenue. But because that same company doesn't have all these different banks bidding for their loan, maybe that private investor, that private lender can charge a percent higher than kind of what, "Would be market," otherwise, if this was a larger company. So there's some structural things where private debt has some additional, let's say kind of attractive traits, if you will, and makes sense versus the public side of things, it's again, largely very efficient. And the large companies take advantage of that. Recently with interest rates being so low, you hear about companies like Microsoft issuing bonds, which is issuing debt to the market, the investors are then lending their money to buy those bonds, and they're at incredibly low interest rates because Microsoft is such a large corporation, has a strong balance sheet, et cetera, et cetera.
Justin Dyer (17:05):
So now from a teasing out potentially future topic as well, with respect to private debt, from our standpoint, we'd much rather prefer private equity in most cases kind of all things being equal for the compensated risk side of it. And then also part of that is also the tax treatment. The difference between lending money versus owning an asset is the tax treatment as well, where lending money, you're getting your interest rate. It's effectively an IOU with an interest payment, that interest payment is ordinary income to you and it's tax at your highest marginal tax bracket. There's some more favorable characteristics over on the equity side that we'll unpack in future episodes. But yeah, hopefully that touches the difference between, again, kind of at least the surface level of private versus public lending.
Brandon Averill (17:59):
Yeah, no, definitely. And I know we'll get into the details, certainly. We're staying kind of 30,000 foot level for sure here, because even within the own piece and within the lending piece, there are all kinds of iterations of different exposures and different characteristics and you have to get pretty nuanced in all that, when you actually go to build a portfolio. But I think the one thing that I'd also be [inaudible 00:18:26], if we didn't hit on because we get the question all the time, but what about gold? And what about crypto, and what about art, and what about NFTs? I mean, NFTs are certainly going to the moon and I think this is a great, I say that jokingly, if anybody can read my face, but I think this is a good lens to start to ask or run those types of questions through.
Brandon Averill (18:54):
So just to bring everybody back, we're looking at, there's really two ways to invest your money. If it doesn't fall broadly into one of these two buckets, then our argument and I would be hard pressed for anybody to argue against this, is that it's investment if it doesn't fall in one of the two, right? It becomes speculation at that point. So we look at like a gold, or a crypto or whatever it might be, you have to ask a question, "Okay. If I own this, can I predict, or can I estimate, or can I come up with some reasonable expected returns based on cashflow that's going to be generated to me?" If the answer is no, then it's probably not an investment. And then on the lending side, am I actually lending money to somebody, are they promising me my money back plus an interest rate?
Brandon Averill (19:46):
So if we take, let's take crypto since it's the hot topic and we apply these fundamentals, right? Number one, "Okay, I'm going to buy crypto. That's very true. How do I value crypto? What can I expect as a return in payment over time?" And there is no model, right? What you're relying upon is somebody in the future valuing that higher, similar to gold, and even similar to residential real estate, if you're buying it for your primary home purpose. So I think that's another thing people get tricked into thinking this is an investment, but you have no cashflow expectation in the future. That is not an investment, right?
Brandon Averill (20:27):
You're buying it for a different purpose and maybe you're speculating that it's going to be worth with more in the future, but you certainly shouldn't call that an investment in our view. And then take the lending lens and, "Okay. Crypto, I bought it. Am I actually lending my money to somebody with a promise to get it back? No." So anyways, I just wanted to make that point. I don't know, Justin, you can certainly rift on that, tell me if you agree or disagree. I think you agree, we know each other well enough.
Justin Dyer (20:58):
No, totally. Yeah, I would just underscore the speculative nature of those examples you're highlight, it doesn't mean Bitcoin or some other cryptocurrency is going to be around in 10 years, we don't know that. What we're saying is, and as I'm explaining that, I'm making that a speculative statement. And that lines up exactly with what you're saying. And there's a gray area, there's a spectrum here, but investing, true investing is the ability to assess an investment, ownership or lending through some lens of commonly accepted valuation practices. The whole crypto space could be changing that, but I guarantee you, the blockchain... I shouldn't say guarantee, we're not allowed to say that. So let me take that back. But the venture capital firms and the private market investors, which again, we definitely like that part of the market, that are investing in these crypto startups, blockchain startups, they are coming up with some sound valuation metrics.
Justin Dyer (22:11):
Sometimes you're pulling in some weird metrics and it potentially in some cases goes back to the 2000 dot com bubble. Some guys are too young, probably listening to this to remember that, or even be really kind of paying attention. But there was very similar type dynamics going on in the market, where interesting companies were being founded left and right. I mean, this is really when Silicon Valley got itself put on the national map, it's been around for much longer than this. But these interesting companies were starting from nothing more than an idea. And they were being valued at these astronomical levels based on some really interesting metrics, where the relationship to actual economics, actual money, actual accounting, let's call it, the language of business. The P&L is there actually, at some point in time, is there going to be profit so that I can actually take claim to, which is the most important question that we're talking about here.
Justin Dyer (23:14):
They got so clouded that the metrics that they were using were just completely unrelated to reality, and there was no real way to get them back to reality. And unfortunately there's this high mind that kind of gets there and you can convince yourself of everything thing. Now, if you're going into it with a speculative mind and you understand that, that's one thing. And it's an interesting topic. You need to really understand what you're doing and right size those type of bets, which we'll probably talk about as well. But in general, if you are trying to build multi-generational wealth, have an impact, really make sure your priorities are lined up. Generally speaking, going down that path, that rabbit hole, doesn't make a ton of sense. Doesn't add to the probability of success of your or unique plan, of your situation. It might scratch an itch, but it probably is an increase in the robustness of your overall situation.
Brandon Averill (24:15):
Yeah, I think that's fantastic. So we went a little long-winded, but we'll wrap up here. And just as a reminder, what we're talking about, at the end of the day, ownership. So when somebody says a stock, when somebody says private equity, somebody says venture capital, what you're buying is ownership. You're buying ownership in a company and we'll talk about next week how does that actually happen? But then the second lesson from today is just lending, or a bond or fixed income, all the terms in our industry. At the end of the day, you're simply taking your money, you're lending it to somebody else, an entity, a government, and in return, they're going to pay you back and they're going to pay you an interest rate depending on the risk of you actually getting that money back.
Brandon Averill (25:02):
So those are the takeaways from today, next week, like I said, we're going to hit on, okay, that's great, we know now we got to identify ownership and we got to identify lending, how do we actually do that? And this is where the world gets really interesting, right? There's all kinds of different vehicles. Do you go buy individual stocks and individual bonds in the public markets? Do you invest in a mutual fund or in ETF? What is as an ETF? Do you invest in private funds or you'll pick individual private companies, or do you lend money to your buddy down the street? There's all kinds of different ways to go about this.
Brandon Averill (25:39):
And we'll get into the vehicles and the ways to do this next week. And then the real fun stuff is like, okay, that's it. Now, how do you actually access that stuff? Who are the players, who are the big brokers and why are they in business? How are they going to sell you this stuff, who are the RAs and the fiduciaries? And we'll get into all this in the future, but hopefully this was helpful to everybody. Head over awminsights.com. The downloadable stuff there, pop your email in if you want to stay on the list and be notified of these in the future. And as always, until next time, own your wealth, make an impact and always be a pro.