In August of 2017, Tesla issued $1.8 billion of senior unsecured notes at face value with a coupon of 5.3%. They mature in 2025. The “unsecured” means that the holders of those bonds rely not on specific assets, but on the company in general to repay the debt. The “senior” means the bonds rank fairly high in the pecking order of investors that get paid off in the event things go south at Tesla. The “face value” means investors paid for bonds in 2017 approximately what they will receive back in 2025. The coupon of 5.3% is the cash returned to the bondholders each year as a percentage of the amount invested.
The investment was not without risk. Tesla at the time was not the Tesla of today. It could have gone under, but it didn’t. As things stand today, an investment in those bonds in all likelihood is money-good. Investors in those bonds in 2017 that hold them until 2025 will receive an annual return equal to the coupon, which is 5.3%.
Meanwhile, investors in Tesla equity over the same period are up 1,198%. That is an annual return of approximately 50% versus the annual return for the bondholders of about 5%.
Oddly enough, the bond investors and the equity investors each invested in the exact same company. A $100,000 investment in the bonds will get you $142,400 if held to maturity. A $100,000 investment in the equity in 2017 would get you $1.3 million if you sold it today.
The difference, of course, is the bonds have a fixed payout. It doesn’t matter what the underlying value of the company is, the bondholders will receive at most the face value of the bond. The bond is a contractual obligation to get repaid a certain amount at a certain time. Equity investors, on the other hand, take whatever is left over. That residual value for equity holders could be zero or it could be something astronomical. The upside is theoretically unlimited for equities.
Generational wealth is created by owning the leftovers. The Rockefellers didn’t get rich from holding bonds. They got rich from equity. The same is true with Bill Gates, Henry Ford, Elon Musk, Mark Zuckerberg, Jeff Bezos, and every other “rich” person you may know. They got rich by owning the residual value of businesses whose value increased over time.
There might be a role for bonds in a portfolio, but building long-term wealth is not one of them. Very little long-term generational wealth has been created through investments in bonds.
Some investors specialize in bonds and a number of those investors are wealthy. As a general rule, we believe, wealthy bond investors became wealthy not through the bonds themselves, but from the fees they charge to invest other people’s money in the bond market. That is not building generational wealth through investing in bonds, it is getting rich through fees charged in the process. Very little long-term generational wealth has been created through the actual investment in bonds.
Incentive compensation for nearly every executive in nearly every company on the planet today is based on equity, not bonds. Executives know how long-term wealth is created. They have little interest in holding the bonds of the companies they manage. They want equity.
The most fundamental question in portfolio construction is what types of securities do you want in your portfolio? We admit it. We have an underlying bias for equities. We have very little interest in bonds. Keeping the residual value in a company whose value is growing is the way to build long-term value.
There is no role for long-term bonds in a portfolio designed for long-term wealth creation, especially during periods of rising interest rates. Bond investors in such an environment are exposed to the chief downside risk of holding bonds (rising market interest rates) and their upside opportunity is contractually capped. Why would you hold long-term bonds in such an environment? Yet, investors as a group continue to blindly allocate a portion of their portfolios to bonds.
Yes, short-term bonds can generate a return for idle cash. The value of short-term bonds is also less sensitive to interest rate changes than long-term bonds. There is a role for short-term bonds in some portfolios. That role, however, is limited to what would otherwise be idle cash and is limited to short-term bonds. There are no long-term bonds in our portfolio.
Equity investors, it is important to point out, are most definitely exposed to downside risks. Investors in Enron or Lehman equity back in the day saw the value of their investments go to zero. That is why equity portfolios, even ones targeting long-term wealth creation, should hold multiple equity investments. No investor bats a thousand. An equity portfolio needs to be constructed to endure the inevitable bad investment, even one that goes to zero. That is the value of diversification. Investing in a number of equities allows for the inherent uncertainty in the outcome of any single investment.
We believe the optimal level of diversification depends on how well the person managing the portfolio can differentiate between the great companies destined for long-term value creation and the Enron’s and Lehman’s that are destined for bankruptcy.
If the manager is good at differentiating the two types of companies and devotes his or her life to doing so, that manager should run a concentrated portfolio focused on the companies he or she believes will create long-term value.
If the manager is lousy at identifying the long-term value creators or prefers playing golf to analyzing companies, a more diversified portfolio is warranted. Our advice, in fact, is to steer clear of the lousy distracted managers altogether. They aren’t worth the time and certainly aren’t worth their fees.
Our portfolio construction advice, then, for people wanting to build long-term wealth is to stick with equities, stick with a relatively concentrated portfolio, and above all stick with a talented manager that devotes his or her life to investing.
