How Stocks Are Like Bonds

Many thanks to Nadav Manham, who, after reading my exchange with Jim Surowiecki, pointed me to a fabulous (if long) article which Warren Buffett published in Fortune in 1977. Headlined "How Inflation Swindles the Equity Investor", it details how a huge amount of the change in stock prices can be very simply explained by considering them to be perpetual bonds with a 12% coupon -- 12% being, in 1977, most companies' ROE.

Since then, of course, US companies have levered up quite a lot, and their ROE is now much higher. But Buffett's article is well worth revisiting all the same. For one thing, it's the best argument I've ever seen in favor of companies retaining earnings rather than paying them out as dividends -- something which helps explain why Berkshire Hathaway (BRK.A) is so dividend-averse. After reading Buffett, you're inclined to think that pretty much all companies trading above book value should do the same. And for another thing, it's easy to see, using Buffett's lens, why stock prices have risen so far since his article came out, thanks to a combination of falling interest rates, low inflation, and higher leverage.

William Bernstein also has an interesting stocks-as-weird-bonds lens, explaining that dividends never fall as fast as stock prices, and that therefore long-term investors actually want stocks to go down, since that increases the value of their reinvested dividends.

What any of this means for today's stock-market investors I have no idea. But at the very least it's a refreshing change from the noisy and unhelpful daily stream of commentary on which stocks are up and which are down from where they opened this morning.

Comments

[jimmy46:]

While there are many interesting comments in that article, I don't believe it explains "How inflation swindles the equity investor".

In the lengthy article there was only one sentence that hinted of that problem:

"""Replacement cost accounting almost always shows that corporate earnings have declined significantly in the past decade."""

That is, depreciation based on historical cost hides the theft of inflation because when the next plant needs to be built, it will cost far more than the one it replaces. And the meager depreciation that had been allowed in the inflationary years will not have been enough to pay for it.

Ideally as inflation increases, depreciation allowances should also increase.
But try explaining that to Barney.

2008 Nov 06 01:35 AM

[User 283977:]

"For one thing, it's the best argument I've ever seen in favour of companies retaining earnings rather than paying them out as dividends"

In companies that offer dividends, senior management is focused on operational efficiencies and returns relative to their competition. Senior management does not manage to their stock price, they manage to their earnings. In that situation, the stock price takes care of itself. In companies that offer no dividends when they could offer dividends, senior managements attention is often focused on stock price. The danger with this approach is that senior management looses sight of their companies business fundamentals in favour of buying/ selling and deal making. Something that could be called a Gekko (from the movie Wall Street) approach.

Buffett's Berkshire Hathaway is a holding company that basically provides capital infusions in exchange for stock sold at a discount. Berkshire Hathaway's risk potential is a lot lower than an individual investors risk potential because they are buying at a discounted price. If things start to go wrong, they can get out at a much lower price than you can while still earning a profit. Berkshire Hathaway's approach, the Gekko approach, is not about building and selling products and services, its about the creation/ capture of wealth through speculative trading/ deals.

I argue that retaining earnings rather than paying them out as dividends would encourage a Gekko approach to company management, and such an approach would wildly increase the speculative potential of stock investing for the average investor. We have just had a spectacular example of the dangers of such an undisciplined investment approach. If you want to speculate, buy Berkshire Hathaway. For companies that provide real products and services,
initiate requirements where dividend returns on the basis of earned income are a mandatory requirement. This should better orient senior management to concentrate on business fundamentals as opposed to stock prices. It would also reduce situations where companies are sitting on billions of dollars of stock owners money with out paying them any return on THEIR money. If a company needs capitalization for a deal, sell more stock.

I don't see a big difference between people that sell Brooklyn bridges and people that sell derivative products with no way of determining true valuation without resorting to what some unregulated rating company, with suspect motivation says they are worth. Society provides protection against Brooklyn bridge con men, but seems willing to accept investment bankers selling hot air who's valuation is based on fantasy. Unregulated security markets operating under the mantra of free markets appears to be more damaging to society than Brooklyn bridge con met, yet we legally pursue Brooklyn bridge men while letting Wall Streets pirates get away with it.

2008 Nov 06 03:28 PM