Investing - The First Question To Ask
Part of an irregular series of posts on the basics of investing
To novices and beginners investing often seems daunting. Even for those with a lot of experience, complexity and obfuscation can still make investment analysis and decision making quite difficult. For some in the industry this is a feature not a bug. They thrive off the confusion.
Fortunately most of investing is quite straightforward in its essence, and for almost everyone successful investing does not require wizardly mastery of mysterious domains. In fact basic analysis from first principles is not just a great starting point for understanding investing in general. It is also a great way to truly understand an investment no matter how complex it may appear.
We can start with this consideration. Every investment essentially falls into one of two categories, which can be assessed by answering a simple question: Am I an owner or a lender?
It is true that there are some nuances in between where an investor has both some ownership as well as some lending, but these are actually quite rare. Most of the time what appears to be a combination can be bluntly placed into one of the two buckets. Let’s leave examination of the subtle exceptions to another time.
An owner has a right to the profits that remain (if any do) after all debts have been paid. Therefore, an owner is said to be “paid last” since every other claim on a business’s capital must be satisfied before the owner can claim what remains.
A lender (creditor) owns a right to a debt an entity has issued or generated. Therefore, a lender is said to be “paid first” in relation to an owner. Among lenders there is an order with some having higher priority. This is important since there might not be enough to pay every lender back in full. Considering that risk, the risk of default, the order of who gets paid based on what they were entitled to has a lot of implications, obviously.
Notice we already have made this attempt at a simple question difficult since a debt holder “owns” the debt investment. But look through that to the relationship the investor has with the entity that now has his money. Simply put: Are you becoming an owner of a business’s assets (in part or in total; for example, suppose you are buying a 25% ownership interest in a restaurant) or are you lending the business assets (money or capital otherwise; for example, the farmer borrowed $1,000 to buy seed and my tractor promising to return the tractor and give me back $1,250 in six months)?
In both cases of ownership and lending there are risks associated with any investment made. For an owner in a particular investment the risk is relatively greater than it is for a lender to the same entity. This should be obvious since the lender has a claim that comes before the owner’s. Since the owner has more risk, the owner should get the opportunity for more potential return.
Notice how this is a much less sanguine statement than the common “more risk means more return”. That mantra is technically wrong or at least meaningless. A better yet still overly simple mantra might be “more risk means the need for more return”. While closer to the truth, it still leaves too rosy a picture as returns are never as certain as risks. An owner has to work hard to make sure his investment has the opportunity for potential return.
A lender has less risk depending on how likely he is to be made whole—getting back the original loan (AKA, principal) plus any interest that was promised or implied. Therefore, a lender should expect less opportunity for potential return as that likelihood of getting paid back increases.
Lenders accept relatively lower return in exchange for relatively higher certainty of that return. This is true both in comparison to owners and among various forms of lending itself. If Fred has to pay Alice back before he pays Mel, Mel’s lower level of certainty leads him to demand a greater potential return in exchange. This is true whether Mel is a lender to Fred or part owner in Fred’s business. All we need to know is that Mel is in line after Alice to know that he needs some form of potential return that is greater than what Alice required (for example, a higher interest rate if he is a lender or a share of profits if he is an owner).
Owners accept relatively less certainty of return in exchange for relatively higher returns. This is true both in comparison to lenders and among various ownership opportunities.
Several essential questions have emerged with more implied from this short exploration:
For a particular investment am I owning or lending?
If I am a lender,
Where do I stand in line? Front, back, middle . . . who can jump ahead of me if certain conditions are met?
How likely am I to get paid back given where I am in line?
Is what I can expect to get back worth the risk?
If I am an owner,
What debts are there that must be satisfied before I will get paid?
How much might I make in the best, worst, likely circumstances?
What probabilities should I assign to each potential outcome?
Is what I can expect to get back worth the risk?
There are many branches to explore beyond this like marketability/liquidity, obligation, term, optionality, recourse, counterparty creditworthiness, and on and on. Yet all of these have to begin with consideration for the question is this lending or ownership.
I know this was a fairly basic post on what most people likely already know or think they know. The point is partially that despite “knowing this already” people so often seem to forget it when evaluating investments or think it isn’t highly relevant to analyzing an investment. On the contrary it the first question one should ask when presented with an investment and all the more important as the complexity of it grows.
