Back to Basics: Six Questions to Consider Before Investing, by Ben Inker

• Inker provides a framework to analyze asset classes by asking six questions.
  1. Would investors buy the asset if there was no risk premium (above cash)?
  2. Where and from whom do the returns come from?
  3. Why would the provider of the returns be willing to offer a risk premium (above cash)?
  4. Have the historical returns been consistent with the risk premium expected?
  5. Have the sources of the returns been consistent with what we expected?
  6. Has something changed to make us doubt the relevance of the historical returns?
• Equities: investors would not buy without a risk premium; returns come from dividends (and stock buybacks; companies willing to provide returns for flexible capital; stocks have returned 6.4% over cash historically; future earnings yield (E/P) looks low (but positive).
• Bonds: asset-liability investors (pension funds, endowments) may buy bonds in the absence of a risk premium to better match liabilities; bond issuers willing to provide a term premium for long-term assets (real estate, property, plant); bonds have historically returned 1.3% over cash, though there have been long (40-year) periods where it has consistently underperformed cash; with yields so low, risk premium for bonds is unreliable going forward.
• Commodities: investors could buy for inflation protection, other would buy only for risk premium; returns are generated from cash, spot price change, and roll yield. Manufacturers (commodity consumers) willing to provide excess returns to lock in prices (Keynes’ insurance theory). Excess return of the GSI Reduced Energy Index is 3.1% historically, though it is negative 40% of the time; the spot returns of the Index has not exceeded inflation over time; cash returns are very low currently. Market has changed now that there is a surplus of long-only index investors. Risk premium unattractive going forward due to low cash returns and significantly negative roll yield returns; commodities index roll yield was 3.6% in the “Pre-Index era”, -2.9% in the “Early Index era”, and -8.9% in the “Index Popularity era”.
• Private Equity: investors would not buy without a risk premium over public equities; returns come from dividends and IPO or buyout; more akin to active management (activist corporate management skill) than a separate asset class; returns have not exceeded public equities on de-leveraged basis; PE market has changed due to a flood of money compared to 20 years ago; unattractive risk premium going forward due to excess capital.
• Venture Capital: investors would not buy without a risk premium over public equities; returns come from exit sales; entrepreneurs and investors willing to fund returns to add value and increase efficiencies; venture market has changed due to a flood of money and angel investors; risk premium going forward is questionable.
• Volatility or Tail Protection: risk-averse investors would rationally invest for protection even without a positive risk premium; insurance providers would demand a risk premium.

Finished: 4-Jan-11. Rating 8/10.