The Cost of Capital

The concept of cost of capital ("COC") is familiar to the corporate treasurer, and it should also be equally so to the investor. The corporate CFO is in the business of "purchasing" capital from investors, and it is in the interest of investors not to sell it too cheaply. Bonds present a simple example. The US government can currently obtain loans from the investing public for 5 years at about 5.8%. This is its COC. A small company with uncertain prospects may be shut out of the bond market entirely, and might have to pay 10%-12% to a bank. On the other hand, in today's inflated market the same company may be able to go public at a PE of 20 times earnings. This represents an equity COC of only 5%. Obviously, unless the CFO's IQ is considerably below room temperature, she will go with the stock offering. Unfortunately, this says little for the discriminatory powers of the average IPO investor in today's market.

The calculation of the true COC of a company selling stock is complex, and involves discounting to net present value all of the company's future cash flow or earnings. However, when considering the aggregate COC of the market as a whole, the earnings yield of the market is a reasonable, and easily available proxy. If you wish a lucid explanation of the COC concept, take a look at March's Asset Class (You'll need Acrobat to read this.) from TAM Asset Management Inc.

I've chosen to compare the earnings yield of the Dow Jones Average versus that of the 5 year treasury note back to 1926. Comparing the two gives a rough index of the COC of equity relative to debt. Below I've logarithmically plotted the ratio of two numbers: the earnings yield of the DJIA (that is, the inverse of its P/E) and the yield of the 5 year treasury note.

Note that the COC of equity relative to bonds soared during the great depression to about a factor of 10 (i.e., with the DJIA earnings yields at around 15%, and 5 year treasury yields of 1.5%). The carnage of the 1929-32 bear market had so traumatized investors that the earnings yields of stocks had to be ten times higher for stocks than for bonds before folks would consider buying them. Then, over the next 60 years the stock/bond COC ratio fell slowly and gradually. It may be that in the 1970s-1980s investors were more traumatized by bonds than stocks, as this ratio has of late fallen below 1.0. We have arrived at a point where the COC of an Iomega (or a ZZZZ Best) is considerably less than that of the US Treasury.

In nominal terms at least, the COC for both stocks and bonds has been falling for the past 17 years. This can be traced to the salubrious economic conditions during this period, with slow but steady growth and falling inflation -- the so-called "goldilocks economy." It may be that we have reached a permanently high plateau of economic nirvana, but history suggests otherwise.

The Cost of Oil

This Time, It's for Real

Remember the oil crises of the 70s? Crude was inexorably heading towards $100 per barrel. Humanity, depicted as a cancer on the face of the planet, was greedily consuming in the blink of an eye resources accrued over the eons. Paul Erlich and the Club of Rome were all the rage, spreading a neomalthusian gospel hairy enough to make you feel like a Christian Scientist with appendicitis. We were all going to freeze in the dark.

Only one problem-- economically speaking, these folks were a few bricks shy of a load. None of them realized that it is human enterprise alone which creates a commodity's value, and if it becomes too expensive production can be increased, or substitutes found. They forgot that towards the end of the last century people worried about how we were going to be able to continue lighting our cities. You see, the major source of illumination of our streets was whale oil, and it was clear even then that we were running out of the beasts. Who would ever have guessed a few short decades ago that the major engine of wealth creation in today's economy would be manufactured from sand?

The end result is that the seers of scarcity cried wolf once too often. Mr. Erlich and his ilk today pack all the credibility of carnival barkers. The conventional wisdom is that we are awash with oil. Let's all pile into our Suburbans and Winnebagos and hit the road.

It now appears, however, that this particular wolf may actually be at the door. Enter Colin Campbell and Jean Laherrere. With over half a century in the oil exploration between them, they analyze the state of the planet's petroleum reserves in the March issue of Scientific American. The picture isn't pretty. Yes, sophisticated seismographic and drilling techniques have increased production. But they also assert that most of the increase in reserves reported over the past few decades simply represents accounting slight-of-hand. OPEC rules award production allotments according to known reserves, hence an incentive to inflate them. There are other reasons as well to inflate reserves--to improve credit rating, attract exploration, or military aid, for example.

Campbell and Laherrere focus instead on the discovery of new reserves. In the 1990s oil companies found an average of only 7 billion barrels per year versus consumption at 24 billion and rising. Further, the iron law of oil accounting, first described by oilman W. King Hubbert in 1956, is that production peaks about 20 years after the peak of discovery. It turns out that the discovery peak occurred about 1975. The relation between discovery and production is represented graphically below. (The graph is taken from the Campbell/Laherre article.)

The question is not when we will run out of oil; the law of supply and demand necessitates that we never will. Rather, we are rapidly approaching the point where oil demand will begin to outstrip supply, and prices will rise. In the 1970s the constriction of supply was artificial; early in the next millennium it will be very real. Eventually we shall compensate with gassification, tar sands, oil shale, and alternative energy sources, but the transition will be long and painful.

Most of you are aware that I disdain macroeconomic analysis in financial decision making, but this is one area that I do not believe has been factored into anybody's security analyses yet. The current goldilocks climate of steady growth and low interest rates may not survive a sustained rise in energy prices.

I'm not foolish enough to spin a scenario of general stock and bond market collapse precipitated by an impending rise in oil prices. However, it is useful to consider just how fragile a favorable current investment climate can be, and how fast changes in investment sentiment can occur. If and when the next severe market decline comes, it will most likely be caused by something completely unforeseen. Obviously, it would be nice to know just how the next market collapse will occur; a 1970s scenario could be hedged by hard asset purchases, whereas a 1930s scenario by the purchase of long high quality bonds. Next time, the right answer may be none of the above.

However, one thing seems certain. If inflation heats up the equity COC will likely rise sharply, with possibly dire consequences for investors. Just remember, at the end of they day we are all selling capital to corporate treasurers. In every transaction there is often a fool, and if you don't know who it is, then it's most likely you.

copyright (c) 1998, William J. Bernstein