Be an Owner, Not Just a Loaner

Editor's Note: This column was originally published Dec. 23 as part of TheStreet.com Value Investor, a premium subscription service by Arne Alsin. We hope you enjoy this special bonus issue of TheStreet.com Value Investor. To subscribe, please click here for more information.

---

One of my investing aphorisms may sound trite, but it's true: Be an owner, not a loaner.

For example, in your community, would you rather be a loaner to or an owner of the corner car wash? Think through the risk vs. the reward.

As a loaner, the risk is that the corner car wash cannot repay your loan. The reward isn't the repayment of your capital; that's legally due to you anyway. The reward is fully taxable interest income.

For the owner, the risk is that the corner car wash will go out of business. The owner's potential reward is much better than it is for the loaner. The owner has the right to all of the income, and he or she gets to participate in the business' growth. However, growth isn't a prerequisite for the generation of considerable reward.

For example, Kroger (KR - commentary - Cramer's Take) could generate zero growth for the next 10 years (something I don't expect, of course). Even with no growth, Kroger's business will generate cash earnings equal to the entire equity value over the next 10 years. (The stock sells at roughly 10 times earnings.)

In the public investing markets, the long-term data are unequivocally one-sided: Owners make a lot more than loaners. Over a period of several decades, owners of equities make roughly double the return of bondholders, or "loaners."

Here's how I see the owner vs. loaner dichotomy for several investment vehicles. As you prepare and review your capital allocation strategy for 2004, consider the risk-vs.-reward equation for each of these investments.

Government debt instruments: If you invest in Treasury bills, notes or bonds, then you're a loaner of your capital to the government. The reward is paltry and taxes are high (levied at ordinary income tax rates) for all of these instruments. After a 20-year record bull market in bonds, the risk is very high that the next major move in interest rates is up. The yield curve is as steep as it's been in modern history. I can't make a case for allocating any long-term capital to Treasury instruments in this environment.

Bank accounts, certificates of deposit: You're a loaner if you invest in a bank account or a CD. You're loaning your capital to a bank. In turn, the bank makes a hefty profit by using your capital. The net interest margin at most banks is about 5%. They'll pay you about 1% in short-term CDs and money-market accounts, while they loan it out at 6% or so, pocketing the difference. (That's where the 5% net interest margin comes from -- a great gig, right?) Rather than loan your money to a bank, buy the bank and be an owner. For example, Washington Federal (WFSL - commentary - Cramer's Take) has the best operating expense efficiency ratio of any thrift in the country. That 5% net interest margin will inure to your benefit as part owner of this well-managed business. And the 3.2% partially tax-sheltered dividend is a higher net yield than you can get from any bank account.

Fixed annuity: When you buy a fixed annuity, you're loaning capital to an insurance company. As with banks, I'd rather be an owner of the insurance company instead. Insurance companies such as Safeco (SAFC - commentary - Cramer's Take) and Aon (AOC - commentary - Cramer's Take) are excellent choices. Both are undervalued businesses with impressive prospects, and both generate a reasonable dividend stream, at 2% and 2.5%, respectively. Unlike a fixed annuity, the dividend yield should grow nicely with Safeco and Aon over time.

Corporate bonds: If you own corporate bonds, you're loaning capital to corporations. If the next major move in interest rates is up, this is not an appealing asset class in which to invest. While high-yield corporate bonds pay relatively high rates, there is risk of default, too. I don't think there is the same risk, for example, in owning a safe, defensible, diversified franchise like Liz Claiborne (LIZ - commentary - Cramer's Take), with its growing free-cash-flow stream. I'd rather own Liz Claiborne than any corporate bond in the marketplace.

Where's the Stock Market Headed?

Is the stock market overvalued? Are the nabobs of negativism (to borrow a phrase from Spiro Agnew) correct -- namely, that we're in a cyclical bear market rally that will unwind very badly? Are stocks about to get clocked?

---

At time of publication, Alsin and/or ACM was long Washington Federal, Safeco, Aon, Liz Claiborne, HCA and The Turnaround Fund, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, TheStreet.com Value Investor.