There are 2 kinds of stocks that value investors can choose to focus on. Alvin explains the characteristics of these stocks using a simple analogy.
Let’s introduce you to Ashton. Ashton is a retiree and he has a House worth $1.5 million (M). But, he didn’t fully own the house which means he still have an outstanding loan of $500,000. He has $600,000 cash in the bank, which work out to be a $1.6M net worth for Ashton.
And, how you get this $1.6m?
You add up the house ($1.5M) to the cash in bank ($600,000) that give you $2.1M and then you minus the outstanding loan of $500,000 that give you $1.6M of net worth for Ashton.
And, let’s say, Ashton is an investment instrument that you can actually invest in. I would believe that you would only pay a price that has below what he is worth and that is a price below $1.6M.
Let’s introduce you to another guy called Earnest.
Earnest, unlike Ashton is a young fledging lawyer, who is fresh out of Law School and has entered into very prestigious law firm. And he expected that his salary will increase at a rate of 10% per year for the next 10 years.
Let’s assume that the net present value of his future earnings would be $1.6M today.
Let’s say Earnest is as well an investment instrument that you can invest in, just like Ashton. How much would you actually pay Earnest for to control his income for next 10 years?
And, I’d also believe that you would only pay a price below $1.6M.
Now, here comes the question, if let’s say, you only have enough money to invest in either Ashton or Ernest and let’s say both are at a price of $1M, which one you actually invest in?
And what would be your reasons?
To answer the question, I think you would look at the risk of investing in Ashton or Ernest. Let’s take a look at Ashton first; imagine that you invests in Ashton for $1M and tomorrow he passes away, what would happen to your investment?
And, I’d say is rather safe because you could still take the house and sell it at let’s say $1.5M and you would still own the cash in the bank. You can pay back the loan after you sold the house and you would be able to net $600,000 (profit) based on the buy price of $1M. So, which means, whether Ashton continue to live or not, it doesn’t really matter anymore.
But let’s say it is Ernest, and if you have invested similarly $1M on Ernest instead of Ashton, and Ernest pass away the next day.
That means your potential reward for your investment would go down the drain. Because, it relies on his ability to stay alive and continue work as a Lawyer in order to earn that kind of income. Sadly if he passes away, there goes the future income as well.
Of course, you can say, that you can buy insurance for Ernest and net a very big profit the moment he passes away. But, it’s not just death that can affect Ernest.
What about critical illness, and if he is unable to work as a lawyer?
Or his work performance is not as good as he assumed to be and his rate of increase in his salary of 10% is unrealistic, instead probably he could only fairly do a 3% per year increment just enough to beat inflation.
So, there are many many uncertainties revolving around on Ernest’s future income and that is why investing in Ernest would be much more risky in my opinion than when you invest in Ashton kind of stocks.