The 4 Types Of 'Dead Money'

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 |  Includes: BAC, GE, IBM, JNJ, MSFT, ORCL, PG, WMT
by: Eli Inkrot

Summary

The phrase 'dead money' is routinely used to describe a poor investment.

Yet this portrayal is often misguided or at the very least lacking description.

This article details the 4 types of 'dead money' – simultaneously demonstrating that each can have very different implications.

Fairly often, I hear the phrase 'dead money' tossed around the financial community. For instance, "Microsoft (NASDAQ:MSFT) was dead money for the last decade" or "IBM (NYSE:IBM) has been dead money for me." The connotation is that these were bad investments. That, despite the uncertainty assumed in partnering with a business, the share price should automatically increase simply because the investor purchased it.

Yet stocks don't know when you bought them; and they certainly don't work on your schedule. We hear the expression 'dead money' regularly, but how frequently do you actually think about what it means? Repeatedly 'dead money' is interpreted to equal 'poor investment'. My contention is that this negative undertone is often misguided or at the very least ill described.

To illustrate my point, I'll walk through the 4 types of 'dead money'.

Cash

This probably isn't your first thought when you think about 'dead money,' but it fits the description quite perfectly. If you literally held it under your mattress or in your wallet, you would have the same amount of money at the beginning and end of the period. It would be 'dead' in that it wasn't productive. Actually, depending on the time period and resulting inflation, holding cash is worse than 'dead money.' For instance, $1 held from 1977 onward has the purchasing power of about a quarter today.

Bad 'Dead Money'

This second type is what people truly mean when they use the phrase. These types of scenarios are unfortunate and do occur from time to time. Think of Bank of America (NYSE:BAC) as an example:

Now this certainly is not to suggest that there could not be a benefit to partnering with this company in the future. Instead, it's merely a comment on the past. Investors leading up to 2007 had the rational expectation of continued profitability. Then the company's earnings fell off a cliff and the share price followed suit.

These things happen. Luckily, a diversified portfolio and long-term time horizon can make up for a few of these occurrences in a portfolio.

Overvalued 'Dead Money'

I would surmise that this characterization takes place just as often as the second type. People might say "Wal-Mart (NYSE:WMT) was dead money" but what they're really signifying is something along these lines: "Wal-Mart has been a great company that I paid too much for." Here's how that looks graphically:

Sure, the price largely stagnated, but you can see that the business was absolutely fine. Unlike BAC, you certainly can't fault Wal-Mart here. Earnings per share grew by about 11% a year and dividends grew even faster, moving from about a quarter to nearly $2. The problem was the expectations involved and the relative valuation. At the turn of the millennium, shares of WMT were trading at 40+ times earnings. It simply took awhile for the price to fall back in line with the adequately performing business.

So when you hear that Wal-Mart was 'dead money' read "I bought a huge company at 40 times earnings, what went wrong?"

And of course the same holds true for companies like Oracle (NYSE:ORCL) and Microsoft during the tech boom or General Electric (NYSE:GE) during Welch's tenure.

Obviously overpaying can't be avoided all the time. If you pay 20 times earnings for Procter & Gamble (NYSE:PG) or Johnson & Johnson (NYSE:JNJ) and it falls to 17 times earnings in the future, that's no great investment folly. But if you keep to Ben Graham's logic of never paying over 25 times average trailing earnings then you might be better off. This doesn't guarantee you won't run into the Bank of America type investments, but it does reduce the likelihood of complaining about the Wal-Marts.

Good 'Dead Money'

Finally, the 4th type of 'dead money' can actually be beneficiary if you categorize it correctly. When someone says that "IBM has been dead money" think about what's happening. First, it's probable that they are referring to a short-term time horizon; few would classify buying IBM at $18 two decades ago as 'dead money.' A real life example of this might be purchasing shares in July of 2011 in the mid $180s and seeing the share price today - 3 years later - at roughly the same point.


An investor might suggest: "I bought IBM at $185 three years ago, now it's at the same price, it's been dead money for me." Yet this type of thinking can often be one-sided. What's not expressed in that sentiment is the underlying business prospects; the fact that IBM has grown since then.

In 2011, IBM earned about $13 per share and paid a dividend of $2.90.

Today, IBM has underlying earnings power in the $17-$18 range and has an annualized dividend of $4.40.

If you thought that IBM was a 'good buy' or at least a rational investment decision with a P/E ratio of 14 and a dividend yield of 1.6%, is it now 'bad' at a P/E of 11 with a dividend yield of 2.3%? Obviously, there are underlying concerns, but frequently these apprehensions turn into opportunities.

We take no such prejudices to the 'real' world. We never say: "oh, milk's been dead money for the last two years, when is it ever going to reach $5?" In fact, if it goes on sale we might buy even more. Long-term net buyers of items should not root for higher prices.

The same ideology holds true if you owned an apartment building or a farm. As long as the asset is producing - adequately giving you larger and larger sums of cash - all is well. You wouldn't say this: "I've been getting a 7% yield each year, but I can only sell it for what I bought it, so it's been dead money."

Yet in the world of stocks people think: "I bought this, it should go up." When in reality, especially if they are net future buyers, this is the precise opposite thing you ought to cheer for. If it doesn't go up, and the business still produces, it could be the perfect opportunity to buy more.

Here's the takeaway: calling something 'dead money' might not be very descriptive and could in fact harm your investing ideology. The first and third types of 'dead money' - cash and overvaluation - are potentially avoidable. Holding too much unproductive cash (above and beyond liquidity needs) and paying 40 times earnings for large companies isn't forced upon you. The second, or 'bad' type of 'dead money' is difficult to avoid but can be mitigated by diversification. Finally, the last type of 'dead money' is often thought of as a poor investment but in actuality it could be an opportunity - a chance to buy at a lower valuation. So before we say that something has been 'dead money' - seemingly 'wronging you' in some way - take a step back to consider the underlying implications of that statement.

Disclosure: The author is long GE, IBM, PG, JNJ, WMT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.