Earnings Yield of AAA Bonds Needs a Margin of Safety

In the article called “Why the Earnings Yield of AAA Bonds is Better than Graham Number“, I talked about the need for valuations of index funds adapting to the macro environment rather than sticking to a fixed valuation number that was set decades ago to the situation back then.

However, I recently came to the conclusion that Earnings Yield of AAA Bonds is a good valuation method that reflects the macro environment at the moment of valuation, it’s a bit too risky.

The risk comes from two parts.

The first part comes from the fact that if all index funds are very close to the Earnings Yield of AAA Bonds, then if following the valuation method I’d still put in 100% of my free cash flow into these index funds. However, buying index funds close to Earnings Yield of AAA Bonds means valuations are almost over-valued, and that any given moment a significant drop in price is very probable.

The second part comes from the fact that stocks are inherently more risky than AAA grade Bonds. Even though I demand that P/B value to be used as margin of safety, but the demand for P/E * P/B multiple being less than or equivalent to Earnings Yield of AAA Bonds assumes that P/E * P/B can deliver returns with the same amount of risk as AAA grade Bonds, which is not the case because Earnings and Book Value (the “E” and “B” in P/E and P/B) can fluctuate a lot, thus making my original pricing decision overvalued just because fundamentals deteriorate.

Both of these has made me consider adding a margin of safety to the Earnings Yield of AAA Bonds when doing future purchases.

As for what degree of margin of safety, I’ve decided upon demanding a margin of safety of 2/3. There’s no very scientific reason why except for the fact Benjamin Graham and Peter Lynch favors that degree of margin of safety, the former for net net stock valuations and the latter for PEG ratio valuations, and I think it’s a good enough rule for my needs for now.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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