I have just finished another insightful article by Howard Marks from Oaktree, one of my favorite financial writers (few others come close). His deep understanding of the complexities of economics and financial markets always leaves a lasting impression on me.
Here is a section:
When I moved from Citibank’s equity research department to its bond department in 1978, I learned first-hand that this is a matter of night and day. On my new desk, I found a machine called a Monroe 360/65 Bond Trader. If you typed in a bond’s interest rate, maturity date, and market price, it would tell you the yield to maturity . . . in other words, what your return would be if you bought the bond at that price and held it to maturity (and it paid). This was revolutionary to me. On the equity side I had come from, there was no place you could look to find out what your return would be.
This highlighted for me something I have always felt most investors do not grasp viscerally: the essential difference between stocks and bonds that is, between ownership and lending. Investors seem to think of stocks and bonds as two things that fall under the same heading. The difference is enormous. In fact, ownership and lending have nothing in common:
Owners put their money at risk with no promise of a return. They acquire a piece of a business or other asset and are entitled to their proportional share of any residual that remains after the necessary payments have been made to employees, providers of raw materials, landlords, tax authorities, and, of course, lenders.
If there is something left over, it is called profit or cash flow, and the owners have the right to share in whatever part of it is paid out. If there’s profit or cash flow (or the potential for it in the future), the business will have “enterprise value,” in which the owners also share.
Lenders typically provide funds to help owners purchase or operate businesses or other assets and, in exchange, are promised periodic interest and the repayment of principal at the end. The relationship between borrower and lender is contractual, and the resulting return is known in advance as described above, again assuming the borrower makes the promised payments when due.
That is why this kind of investing is called “fixed income” – the income is fixed. For the purposes of this memo, however, it might help to think of it as “fixed outcome” investing.
This is not a difference in degree, it is a difference in kind. Ownership assets (things like common stocks, whole companies, real estate, private equity, and real assets) and debt (bonds, loans, mortgage backed securities, and other streams of promised payments) should be thought of as entirely different, not variations on a theme. They have different characteristics and potential, and the choice between them is one of the most basic things investors must decide.