Investing in a company's debt vs investing in its equity

2022-09-20T07:27:54+0000

We hope you found our recent risk scoring updates insightful. In case you missed them, here are links to both blog posts on the topic:

In this blog post, we cover the main differences between investing in a company’s equity (stock) and its debt and explain why you should probably analyze your debt investments differently than equity opportunities.

Let us give some context.

In recent years the world of investments has been booming across the globe. We can notice an especially strong activity in the equity markets. As more people got into the world of investing, this, inevitably, also gave a boost to alternative asset classes such as crowdlending.

While the purpose of any investment is to generate returns in the long-term, the means to and the strategies behind differ very much based on the asset classes you choose to invest in. 

We frequently see that investors try to replicate their equity investment strategies and due diligence process to loans too. This might work in some cases but there are fundamental differences between the two asset types that we must carefully consider.

Consequently, today we will attempt to shed some light on how loans as an investment product differ from traditional equity investments like stocks. We will also cover what this likely means for your investment opportunity analysis.

For the purpose of this blog post, we will only focus on the fundamental differences between the two investment types and not get into the details of specific investments as there are vast differences among various markets, the status of the company (public vs private), industries, and much more.

Fundamentals

Equity investments

Let’s start with the very fundamentals of equity investing. 

When you purchase shares of a company, you, effectively, attain ownership of a part of the company and, hence, become its shareholder. This means that, in most cases, you become entitled to the company’s dividends and, sometimes, also to voting on important matters.

There are 2 fundamental ways you can profit from equity investments:

  1. Growth of the value (price) of the shares you hold
  2. Dividends from the company's profits

While dividends are usually paid regularly as you hold the shares, you can only realize a share price appreciation by selling your shares to someone and, hence, losing your part of the ownership of the company.

Debt investments

When it comes to debt investments, we have a very different picture. As a debt investor, you don’t receive any ownership of the company you lend funds to and, hence, there are also no shareholder rights assigned to you. Instead, you simply become its creditor that only has the right to receive the funds you have lent (principal) and the interest agreed upon.

As a result, the return on your investment is generated from fixed interest rate payments. 

While sometimes there is a possibility to exit a loan investment by a sale of it on a secondary market, most loans run till maturity or are bought back prematurely when the borrower chooses to make the final repayment.

Comparison

Upside potential

As the value of the shares you hold can, theoretically, increase infinitely, your potential “upside” (returns) from equity investments is unlimited. You don't, however, know how the value of the company will develop, so the true potential upside remains unknown.

Loans, that only offer a fixed interest rate, on the other hand, can only yield as much as the interest rate that is agreed upon; hence, their potential upside is known and limited. Even if you purchase a loan on a secondary market at a steep discount, which is too complex for most inventors, it can still only yield a particular return.

Downside risk

We saw that the return potential of equity investments is much more appealing than that of debt. This is where most people stop their analysis. We must, however, also consider what happens in the worst-case scenario.

At first glance, you might think that both equity and loan investments have an equal potential downside. If a company you have invested in goes bust, you can lose up to 100% of your investment regardless of whether it is into equity or debt.

While that is true on paper, there is more to it. 

If a company goes bankrupt, a bankruptcy administrator takes over the control of the company’s assets and uses them to cover the company’s obligations. 

Upon asset liquidation, debt investors have a substantial advantage over equity holders. Any proceeds that are received from the sale of the company’s assets are used to first repay the creditors (debt investors). The equity holders are entitled to any proceeds only after all the debt obligations have been covered.

This means that, in case of liquidation, the company’s equity serves as a safety buffer to debt investors, because as long as the loss in asset value is lower than the equity of the company, the debtholders will still be repaid in full.

Stability

Another important aspect to consider when viewing loan and equity investments is the stability of returns they offer. 

While equity investments are thought to generate roughly 7 to 10% annual returns on average in the long term, there can be enormous volatility of returns in the short and medium term. 

Besides being nerve-wracking to experience for almost everyone, this can cause a special headache to investors that might be in a need to exit sometime in the near future. 

On the other end of the spectrum, loans, that have pre-agreed interest rates and a clear repayment schedule, in most cases, allow for more certainty in planning the returns and cash flows from your investments.

Now that we have covered the basic differences, let’s see what could this potentially mean for your investment selection process.

Main Implications

As we saw, equity investments can offer unlimited potential returns. If things go wrong, they are also likely to lead to a complete loss of the invested capital (as debtholders get paid first).

That is why, equity investors (investing in individual companies’ stocks) typically place most of their due diligence focus on assessing the future potential of a particular company. 

Can it grow into a dominant market player? Can it sustain its dominance over a long period of time? These are just some of the questions that we try to answer.

If you are a prudent investor, of course, you also try to assess the company’s past performance and determine whether it is unlikely to run into trouble. The main focus, however, still goes to the future potential assessment as, if there is no bright future, there is also no return for you as an equity investor (the exception being dividend-focused investments but there too you want to ensure the company’s growth prospects).

When it comes to investing in debt, on the other hand, we already know what the return will be in the best-case scenario. We, therefore, should only care about the company’s ability not to go bust and to repay us our debt with the promised interest. 

In other words, as long as the company does not default, we don’t care whether it grows its profits and whether a competitor will take its position 20 years down the line. 

Consequently, when evaluating the loan investments, it might be a good idea to put much more effort into understanding a company’s ability to repay the debt and not worry so much about its long-term growth prospects. Ideally, you would want to avoid too risk-seeking projects as a debt investor.

Furthermore, when assessing loan investments, you should not look for “golden tickets” or companies that will make you rich quickly. Rather, you should weigh the interest rate that a particular company offers versus the risks of it defaulting on your loans. 

We try to help investors do that by providing our risk-return scoring that you can see in our Investing Guide. 

We hope this helps!

Cheers,

—Ričards

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