An Investment Pays You To Borrow Your Money. It’s That Simple.

Paul Winkler: Welcome to “The Investor Coaching Show.” Hi, I’m Paul Winkler. I talk money and investing around here. And there’s always something to talk about in that particular area, that’s for sure.

You Can’t Predict the Future

What a week, huh? What a week.

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You just never know what’s going to happen. That’s kind of the theme of this show. You don’t have to predict the future to be a successful investor. 

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And Lord knows we have lots of evidence that people just don’t seem to be able to do that. I just watch the TV programs and I get a kick out of it. People say, “Well, I didn’t expect this.”

Well, of course you didn’t expect that. Nobody expects the stuff that happens in stock markets because it’s always something new and something you don’t expect. And trying to predict this administration, especially, I mean, it’s just really, really hard to do that.

But the reality of it is, you don’t have to be able to do that to be a successful investor. But it’s always fun for me to just kind of walk through the things that happen. And it really is a testament to the work of the academic researchers that I have talked about for years on this show, how they’ve come through and they’ve said, “Hey, this is kind of how stuff works.”

I don’t have to know what’s going to happen in the future to be successful, but here’s the thing that I’ve often found is that anytime something goes against something that I have learned from academic research, evidence-based research, anytime something is put out there as an investment, “You ought to be thinking about this,” or “You ought to consider doing this and you ought to do this,” and it goes against that research, I’ve always just come out on the show and said, “No, I don’t think you ought to do that.” It just doesn’t line up.

I’ll give you an example. When it comes down to investing, there is this idea of cost of capital. I’ve talked about it many times, that people are willing to let you use their money.

Let’s say that you are in need of money for a mortgage or something like that. They’re going to let you use it, but you’re going to have to pay them interest. When you go to the bank and you put money in the bank, you get paid interest on your deposit.

You’re letting them use your money, but you’re going to actually charge them because, hey, there is a value to your capital. It has a time value, time value of money. So you are going to charge an interest rate that is competitive and they won’t let you charge any more simply because if you try to charge too much, they’ll go someplace else.

No-Risk Investments

I’ve had a lot of people come in recently and say, “Heard your whole segment on Yrefy.” Now there’s a new spokesperson and they’re telling me all about it. I’m going, “Yeah.”

One guy just made the comment, “Yeah, anybody that thinks that somebody’s going to pay you 10.5% to use your money is crazy. Why would anybody do that? If there’s no risk, why would they have to pay you that much? That doesn’t make any sense.”

And that’s exactly right. Now, there are spokespeople that are paid a boatload to say whatever the company wants them to say, and I’ve talked about that. I’ve gotten into the disclosures.

Read the disclosures yourself. Go out there and read the disclosures yourself and you’ll go, “That’s why they’re saying what they’re saying. Oh, okay.”

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Recognize that anytime somebody’s going to pay you a higher rate of return than normal, it doesn’t make any sense. 

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They wouldn’t have to pay you any more than a bank would have to pay you if there were no risks involved. And the risks are tremendous. The risk of you not getting your money back is tremendous. It’s a problem.

Now, that goes for the stock market as well. There is a cost to using your capital, and that is the earnings. Anytime companies are really great and they’re well-liked and they’ve got high growth rates, well, what happens in those particular instances when you really have really, really high growth rates is that you have to pay a lot for that.

Matter of fact, I was showing somebody this week. I was actually making a case that if you look at, oh, let’s say periods of time where the growth rate in the economy was rapid, like the late ’90s, technology was flaming hot.

During that period of time when technology was flaming hot, you had very, very high prices of companies compared to their earnings. And that’s because in order to get the earnings of the company, you have to pay more because the future earnings were going to be even greater if the growth rates came through.

And if this is a little bit confusing, let me break it down. Let’s say that you have a type of company that normally sells for 10 times earnings. And that would be a value company, typically, that sells for around that.

So I’m looking at it going, “Well, I get $1 of earnings for every $10 I pay.” But all of a sudden, we know that those earnings are going to go to $2 in a very short period of time.

Will anybody let go of that company selling for $10 for a dollar of earnings for less or the same amount if you know that the earnings are going to be $2 in a short period of time? No, you might go and push up your price to near $20. And the reason being that the ratio would remain the same: 20 is to 2 as 10 is to 1. So that makes sense.

The Problem With Commodities

Now, this is the thing that I’m always looking at when I’m looking at investing. Anytime that I hear something, I hear something in academia where there is no cost-of-capital story, there’s no paying to use your money, or something sounds a little bit off, I will go, “No, I’m not going to touch this.” I would walk away from it.

One of those examples would be like gold, or it would be Bitcoin, or it would be any kind of a commodity. And it was interesting because of one of the articles that came out this week. Remember I was talking about this? Gold actually had a run-up, and there was a big jump in the value of gold, and people are getting excited about it.

I’m going, “Don’t get excited about this stuff, guys. There’s no cost-of-capital story. Gold goes up and down with supply and demand.”

And that’s what makes it go up. It’s not because there was a growth in earnings or anything like that. There are no earnings.

Now there are if you own mining stocks, but that’s a different story. Well, there was an article that says some central banks have been selling their gold and then they’re saying, “That doesn’t mean you should too.”

And I would disagree. I don’t want to own gold. I have no desire to own a commodity — unless you’re going to wear it.

That doesn’t make a whole lot of sense to me. But it’s interesting to me that the central banks have been selling, and that’s part of the reason that gold prices have gone down.

And then I saw another article that was just talking about the amount of mining. I was looking up, I can’t remember who it was, it was something like Oceanic, something like that was the name of the company. They were a company that was going public and they were actually, they were on, I don’t really know who they are. I was kind of curious whether they are actually doing any mining at the bottom of the ocean just based on their name, but it wasn’t.

It was just that they’re actually transatlantic. They’re a company that actually does business all around the world, so that’s where they got their name. But I was blown away by how much gold they mine on an annual basis.

Now think about this. If you have something whose supply goes up because somebody can mine more of it, what happens or what can happen to the value of it? It can go down. Well, it can also go down if central banks decide that they want out of it.

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So that to me is the problem with commodities in general, especially if you can increase the supply of it or the demand can fluctuate. 

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Let’s say if the demand goes down, as in the case of the central banks selling, that can drive down the price. So anything like that, cost of capital.

Closed-End Funds

So I’m really big on making sure that that is something you consider in the investing process. Is there a cost of capital story that leads to returns? Which leads me to a question.

And by the way, if you want to ask a question for the show, you can actually go to the website, paulwinkleer.com. You can go to the content section. You can ask a question there.

Other way that you do it is paulwinkler.com/question or paulwinkler.com/questions. You can pluralize it, and it’ll get you to the same spot.

But a question was coming in about closed-end funds (CEFs). And I appreciate the question about that.

“Paul, what do you think about these? Is this something that you recommend? And what is a closed-end fund?”

Well, most funds, if you are familiar with investing, you’re probably more familiar with what are called open-end funds. Open-end funds are funds that are traded on a regular basis, day in, day out.

When you look at the major mutual fund companies that advertise on TV and magazines and those types of things, those are open-end funds. So the big fund families, that’s what you’re looking at right there.

If you’re looking at, let’s say, ETFs, that would be more like an open-end fund. It’s an exchange-traded fund. It’s going to be a little bit different, traded throughout the day on exchanges, and an ETF is going to be like that as well.

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A closed-end fund’s a different deal. They issue a certain number of shares, and then that’s it. 

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You have those numbers of shares and those shares trade. So they invest in something.

And we used to, back when I was a broker in my deep, dark days as I like to call them, that was one of those things that we were told to get out there and sell. I never sold any of them because I was so analytical.

I would tear this stuff apart and I’d go, “I don’t care for this. I don’t like the way it sounds. No, I don’t think I’m going to do that.”

So I stayed away from that. So that was one of those things that I just didn’t think made a whole lot of sense.

Reinvested Earnings

But you had these things, and they could trade at a premium or a discount to the assets that were underlying because they were closed and they traded after in different types of markets, you might have a bunch of assets that are held, a bunch of stocks in companies, and you might have this thing selling for a premium over, or you might be having it sell for less than that. And sometimes people make it out to be, “Hey, that makes it so that it’s more valuable and it’s more enticing.”

And I’ve seen things out there talking about having high income potential for these things. They’re popular for generating high income and got dividends and interest and they make them attractive for taking income for income-focused investors.

And I would tell you that is not the way you take income from an investment portfolio. As a matter of fact, I have a whole income guide out there about this. Don’t do this.

When you’re buying a bunch of dividend-paying companies, companies that pay a lot of their profits back, think about the profits of the company being split two ways. Companies can pay the dividends to you, or what they can do is they can plow them back into the company. It’s called reinvested earnings or retained earnings back into the company.

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Now, if a company is paying all their earnings back to you, the end investor, that tells you that maybe they’ve run out of ideas. 

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Think about it that way. Maybe they don’t know what else to do with the money than pay it back to the end investor. That’s number one.

Number two, the other thing is this: Companies that pay high dividends tend to be more distressed companies. So if I’m an older person and I’m trying to live in retirement, does it make sense to me to just go and buy a bunch of distressed companies? Probably not. It’s probably not a great way of doing things.

Using a Lot of Leverage

The other thing you find with closed-end funds as well is they tend to use a lot of leverage.

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In other words, they borrow money to try to magnify gains and losses. 

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And that is exactly what got people into trouble during the Great Depression is leverage. When you buy something and let’s say you own it long, you own a stock long or a group of stocks long, and they go up and down in value, that’s one thing.

Now, if you can borrow money at a lower interest rate, let’s say you borrow it at a few percentage points, and let’s say you expect the return of your investment to be 20% or something like that. And you can borrow some money, you borrow it at 6%, and you actually invest that money and you pay back the 6% that you had to pay to borrow the money.

But if the thing that you bought with the money goes up 20%, hey, no problem. I mean, that’s great. I got an extra 14%. So that’s really great and everything.

There’s a problem. If it goes the other direction, you’ve got to pay that back, and your asset went down in value.

And that’s exactly what happened during the Great Depression. People lost their cans. They lost it when markets moved the other direction.

And there were people making money hand over fist during the 1920s, and they said, “Hey, you know what? We can make you even more money. Why don’t you borrow? We’ll give you a loan, a margin loan.”

But the problem was you had a margin call and everything went the other direction. Now, the other thing, the reason that I avoid closed-end funds, don’t use them at all in my practice ever, is because they’re typically actively managed. There’s going to be a lot of buying and selling and trading of assets in there, trying to beat the market.

Now, if you’ve heard me talk about this at all, open-end funds, I’ve talked about more, ETFs, I’ve talked about more. In trying to beat the market, you have something in the neighborhood in the last 15 years, it’s something like 90 to 92% of professional managers investing in large U.S. stocks have failed to match market returns.

When you look at small company stocks, it’s something in the neighborhood of like 97% have failed to match market returns. And if you look at the data on that, it’s been that way for years, and I’ve been talking about this for 25 plus years, that it’s that way.

The Data on CEFs

Well, if you look at the data on CEFs, on closed-end funds, it’s no different. It’s actually often a lot worse. You know why?

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It’s because they typically charge more. So that’s why these investment firms love to sell this stuff: They can make more money. 

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If you can charge a higher management fee, and if you have the same dynamic happening where most investors will choose an investment like a closed-end fund that happened to have beaten the market over the past five or 10 years, and then people think that, well, the reason they beat the market was because of skill, and they don’t recognize that it’s luck.

Like I said, you have something in the neighborhood of 97% of professional managers with small company stock funds underperforming the market. Well, somebody would look at that 3% that outperformed and say, “Well, that’s where I want to invest. Those are the people that are really, really good. How about if I just put my money with those people?”

Yeah, of course, “97% of them can’t do anything to beat the market. I’m just going to hire because I’m special. I’m special. I’m just going to put my money.”

And you find that with wealthy people too. Let me tell you, by the way, why did Bernie Madoff get away with what he did? You think about it.

He came out and he said, “I make this rate of return every year, year in, year out, and I have this great track record.” And he would announce how wonderful he was.

And the returns, you look and go, “Wow, yeah.” And it was wealthy people that fell for it. Why?

Quite often, I’m going to tell you, it’s because of a sense of entitlement. “I’m really wealthy. I’m really smart. I’m entitled to better returns.”

So that’s what we’ve got to watch out is our egos can really get in our way when it comes to money and investing. Watch out for this stuff. So closed-end funds, not a fan. Hope you get why now.

More Americans Are Breaking Into the Upper Middle Class

So from time to time, I’ll have conversations with people that are just, “The glass is half full. Things are just not so good. Things are getting worse.”

And as an investor, it’s easy to get into that kind of a rut of thinking that things aren’t so great. And I’ve had conversations with people — a lot of people — over the past couple of weeks, that’s kind of, I’m laughing, I’m just thinking about this cartoon.

There was a cartoon. There’s this doctor, the guy’s in a doctor’s office, and the doctor says to him, “Well, here’s the news. You’ve tested positive for being too negative.” Isn’t that the case for a lot of us?

It’s just so easy to watch the TV and watch the programs out there and hear just all the terrible negative stuff going on, and it’s easy to get in that place. But how about this one?

“More Americans Are Breaking Into the Upper Middle Class” from the Wall Street Journal. “Research shows that ranks of higher earners have grown markedly over the past 50 years, while lower rungs of the middle class have shrunk.” Yeah, so you hear that the middle class is shrinking, but where are they going?

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They’re not going to the lower income. They’re going to the upper income is what’s happening. 

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And I was actually talking to some of the folks around the office, and I said, “Isn’t this interesting?” And this chart that’s in this article from the Wall Street Journal that actually shows that.

I said, “You know where that chart is? ” And they’re like, “What?” And I said, “In a workshop I taught 10 years ago.” No kidding.

This is something we’ve been talking about for years, that this was what was happening. And kind of the way I look at stuff, I think a awful lot about, and I guess it was just my upbringing and being an economics major and just how deep we got into the data when I was in school.

We would really get into the data on what the incomes of people were, lifestyles. We would look at their standards of living and things like that.

Are Things Worse Now?

One of the things I pointed out here on the show many times is that people are like, “Well, the things are worse now. Things are worse.”

And I go, “Do you realize that people are living in way bigger houses now than they used to live in back in the ’70s? Do you realize that it was not unusual for a family to be living in a house that was less than a thousand square feet?” Now it’s really kind of odd. You don’t see that very often.

Do you realize that people are driving cars now that you don’t get into and pray that the doggone thing’s going to start? Yeah. Do you realize that you have more TV channels on your TV — and that may not be a good thing — than just three? I mean, when I grew up, we had three, right?

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Do you realize how good we really have it compared to what we used to be dealing with? Do you recognize that? 

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I just think about the technology that we have. If I wanted information on something, I had to call the operator, and the operator would come back, and they would go do research.

This is weird. I mean, people forget this is what happened. If I wanted to know about some arcane piece of data, you’d call up, and then the operator would go back, and I don’t remember if they call them operators, but they would actually go back, and they would pull up a book, and they would pull up the information, and come back and give you the information.

And it was just crazy. Now we walk around with personal computers that are way better than anything they used on the Apollo, right?

I mean, just literally data at our fingertips, and we think, Gosh, things are just so terrible right now. But what was interesting in the article was that they were talking about these people, and they said, “Well, so this is what’s going on. Your income is a lot better. Your income has outstripped inflation.”

The Standard of Living Has Been Going Up

I often talk about that as well. If you look at Social Security, the COLA on it, the Cost of Living Allowance on Social Security is based on the labor inflation data. Well, that is a higher inflation rate than the CPI, the cost of goods that we actually tend to purchase, how they’ve gone up.

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Since labor inflation is a higher number, that is telling you that people’s standard of living has been going up, okay?

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And you look at these people that are being interviewed in this particular article, they said that married, and couples have been getting a better shot at getting in the upper middle class in part because they often have two incomes that they’re doing better. They’re talking about people, college degrees, they’re actually doing better as a whole. More people are getting college degrees.

And then you have this idea, I’m looking at people driving luxury cars to high school. I mean, I had to laugh about that one because I remember the vehicle I had.

Number one, I didn’t even have a vehicle in high school. I didn’t even have one. Then, when I got out of high school, what did I drive? A ‘68 Dodge van with a shovel U-bolted to the leaf spring so that it wouldn’t go through the floor.

And then after that, the next car I got was really, really nice. An AMC Pacer. All my friends called it Mr. Bubble. It was awful.

And I remember, I would go to friends’ houses, and I would just pray I’d get there. And one of the things that was funny because I found out why my car would keep stopping on me. It turned out that somebody at some point had actually replaced the gas tank on it, and they left the receipt for the gas tank. They left it in the nozzle, and it went into the tank, and it would plug up the fuel lines.

You think about that. Now, what do you see? You see kids driving up to high school in luxury cars, and you think, Oh, we got it so bad. It’s so terrible out there.

Pessimism About the Future

Then the thing that I thought was funny in the article is saying these people are still, they still feel pessimistic about the future. And I go, “I guess that’s just human nature, isn’t it?”

The glass is half full, and quite often I’m telling my kids, “Self-talk, guys, rumination.” What you’re saying to yourself, monitor what you say to yourself about how things are going, because if you think you can or you think you can’t, as Henry Ford said, you’re probably right.

We have this tendency to think that things are bad and they’re not going to be good, and we kind of walk around with a big cloud. It’s kind of like, what was that guy? It was like in “Hägar the Horrible,” wasn’t there a guy, a character in Hägar or somebody, one of the little cartoons, and he’d walk around, and he had this big cloud that was raining on him all the time.

That’s what I often think about. I think sometimes we just got to look at what we have around us that’s really great. Count your blessings, look at things that are going well, because I’m telling you, life’s too short to focus on the negative stuff all the time, number one.

Number two, recognize, because people worry about stock markets, right? You think about markets.

If things are bad in the future, that means the stock market could go down, right? That’s kind of what goes through our minds. Recognize that even during bad times.

Now, markets will go up and down. Face it, they do. That’s the way stock markets work.

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But even during recessions, economic downturns, markets tend to go up more than they go down. 

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You can’t predict it, but recognize that even if things are a little bit difficult in markets, because companies are run by people, people will do whatever they’ve got to do to turn things around when the economy gets bad. So I don’t ever even worry about it for that particular reason, but just recognize it just makes you miserable as a person to constantly focus on the negative stuff.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.