I was recently reading through some of the financial statements of Altria, the tobacco company that is either a cause of death or wealth depending on whether you created a relationship with it as a customer or stockowner, and was struck by how the management has chosen to structure the business over the years: (1) first, it is loaded up to its gills in debt, carrying $14 billion in debt on the balance sheet which demands $1+ billion interest payments, (2) it keeps almost no inventory on hand, as the tobacco produced is quickly sent out to suppliers almost instantly, (3) and lastly, it dang near leases everything out, principally through Philip Morris Capital Corporation.
I looked through to the large American banks, consumer staples, and other food companies, and saw the same thing in varying degrees. It led me to this conclusion: Benjamin Graham’s advice that corporate bonds are a much safer place to store wealth, compared to common stocks, is no longer typically true among most large American companies.
The trifecta of high leverage + no inventory + leased physical assets has changed since Graham’s time, and I don’t think there’s a meaningful difference between the common stock and bonds issued by most large American companies anymore. If you buy a McDonalds bond instead of McDonald’s stock, or a Johnson & Johnson bond instead of Johnson & Johnson, you are cutting the legs off the potential to achieve 8-12% long-term returns (plus, the cash payout that goes up every year along with that) to take in 1%, 2%, or 3% permanent returns, but you’re not getting anything back in additional safety.
The appeal of being above common stockholders in the event of bankruptcy has become an illusion of security; if the company goes under, everyone’s getting screwed, and the difference between the stockholder losing 100% and the bondholder losing 90-95% becomes negligible at best. Meanwhile, assuming the company continues to survive and thrive making cash profits, the common stockholder is going to build vastly superior wealth to the bondholder. Defensive allocation makes sense if you are exposing yourself to significantly less risk, but if you are making decisions that have effectively become distinctions without differences—then all you are doing is placing a ceiling on the wealth you can build without cushioning yourself on the downside in anything that resembles an equal degree.
Going forward, it seems the purpose of bonds in a portfolio should be based on governments rather than corporations. U.S. Treasuries or general bond index funds of global countries actually adds meaningful diversification and income for someone who is looking to do so. At one point in time, the purpose of buying Wells Fargo bonds instead of Wells Fargo stock was that you might get 70% of your investment back if Wells Fargo went bankrupt, and this was seen as an acceptable tradeoff for missing out on stock price gains and dividends if you were an ultra-conservative investor.
But, it’s your portfolio—you get to determine what to do. All I say is look at the leverage, inventory levels, and lease arrangements for any company you seek to purchase a bond in, and then determine whether you are actually getting something that resembles risk protection. Draw your own conclusion on that.
*By the way, this is why I focus on excellent dividend companies on this site. With Exxon, Nestle, and Johnson & Johnson, what happens in the event of bankruptcy is always going to be a theoretical exercise. The benefits of focusing on the common stocks with the safest payouts leads to such a better life than focusing on the corporate bonds (especially at today’s rates) of such companies that the acts of wealth-creation omission by choosing corporate bonds over common stocks would actually have ruinous effects on your wealth-building process over the decades, only you wouldn’t realize it because that’s what gives acts of omission their potency: they are real but invisible.
Originally posted 2014-06-16 07:57:17.