Home / Opinion / What makes some equity qualify as ‘investment grade’?

The holy grail of investing is to have lower risk and higher returns. But how difficult is this to achieve? Let us give it a try.

Low risk means the chances of losing your capital should be low. High returns means more than what the market returns.

Two primary types of securities that investors are aware of are debt and equity. Within debt, low-risk debt instruments have high credit ratings, and are typically rated investment grade. But what is investment grade? In debt or fixed income or bond investing, bonds are rated based on the fundamental financial characteristics of the business into various rating categories. Ratings of BBB or higher are usually considered investment grade. What this means is that the company issuing the bond can meet its financial obligations under most normal, or mostly, even under adverse economic conditions. Thus, investment grade bonds provide safety of capital. However, the returns are fixed and relatively lower.

So, how does one combine the low risk, i.e., safety, of capital with higher returns? Benjamin Graham had once said regarding bond investments that the theoretically correct procedure for bond investment is first to select a company meeting every test of strength and soundness, and then to purchase its highest yielding obligation, which would usually mean its junior rather than its first-lien bonds.

What Graham meant that if a company is strong and sound, then it does not matter which security one chooses for investment from the viewpoint of safety. If the company’s business model and balance sheet is safe and strong, then so are all of its securities. If the company’s business model and balance sheet are unsafe and weak, then its securities are at risk as default on the junior-most obligation will also trigger a default, and which will mean that all the senior securities will automatically be at risk.

The obligation that is even more ‘junior’ than junior bonds is equity. If the yield on equity is more than that of higher-rated obligations (company’s bonds), then one should invest in equity.

But what is the ‘yield’ on equity? Is it a legal obligation of the company? How does one estimate the yield on equity?

First, one can look at the dividend yield of equity. If the dividend yield of a safe and strong company is higher than the bond yields, it is probably a good equity to buy. However, even if the dividend yield is lower, but the earnings yield, i.e., the inverted price-to-equity (P-E) ratio, is higher than the bond yield, then, too, it is a strong investment possibility. Assuming that the earnings of the company are not going to fall below the current levels, under most circumstances, one could use the inverse P-E ratio as the yield of the company. This is because earnings are partly paid out as dividend and the remaining is reinvested in new projects, which will grow the company’s book value and provide higher earnings in the future. Effectively, the shareholder is getting something similar to a fixed deposit with reinvestment and compounding of her interest coupons.

In reality, the yield-to-maturity of the company could be even higher if the earnings are growing. More sophisticated analysts could estimate this on a conservative basis. But this higher yield should be used only to understand the potential upside and not to compare against bond yields.

Bond yields of the same or similar companies should be compared with the earnings yield, and if that is higher, then one can look at the company’s equity as a possible low-risk investment.

Assuming that the company has a strong track record of growing safely without issuing new capital in the form of either equity or debt, then it is likely that one is also looking at higher returns than the current earnings yield.

So, you have just created a low-risk, long-term, high-return instrument, i.e., an “investment grade equity".

But before you pop open the bubbly, a word of caution. You should keep in mind that equities are more volatile in the short term (i.e., less than 3-5 years) as compared to debt. Hence, even though the risk of permanent loss of capital in strong and safe companies is lesser in the long term, it is possible that in the short term, a company could quote significantly below the buying price of an investor for a substantially long period, i.e., 2-3 years or more.

If you are forced to sell during this time frame, you could lose a significant part of your invested capital. However, long-term holders of equity bought at high earnings yield are likely to get much better returns.

Most companies whose equity can be characterised as investment grade are cash rich, with high profitability and probably zero or no debt. However, there might be some temporary near-to-mid-term issue that is pulling the share price down, and hence, its high earnings yield. This usually happens when growth is not clearly visible in the next year or two due to various temporary circumstances.

In identifying investment grade equity, one should be mindful of guarding against cyclicals.

Cyclical companies show high current earnings yield at the peak of their business cycle. After this their earnings fall. One should use the normalised earnings, as mentioned above, to calculate the earnings yield.

But is investment grade equity a theoretical concept, or are such opportunities actually available in the market?

Investment grade equity is available quite frequently in the market. What an investor has to do is develop the ability to analyse whether a company has a stable business model and a safe balance sheet. Once that ability is developed, it will be fairly easy to spot investment grade equity opportunities.

Armed with investment grade equity, you should remember to always diversify. Even investment grade bonds cannot be invested in a concentrated portfolio. Diversify adequately; say, 20-25 stocks across at least three to five sectors.

This investment grade equity portfolio is probably as close as you can get to the holy grail of investing. You now have a low-risk portfolio which, if held over a long period of five years or more, can preserve capital. Further, this portfolio is also likely to provide high returns over that period.

Thanks, Graham, for once again showing the way. Thanks is also due to his disciple Warren Buffett, who spots such opportunities regularly and explains the rationale as well.

Vikas Gupta, executive vice-president and chief investment officer, ArthVeda Capital.

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