How Did Bill Gross Get It So Wrong?

Includes: AAPL, SPY
by: Ted Barac

Much has been written about Bill Gross' pronouncement that the "cult of equity is dying." To summarize, Gross believes that the historic 6.6% real return (after inflation) of equities since 1912 is an anomaly, because real GDP growth over the period was only 3.5%. In that regard, Gross stated:

"If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy's GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?"

The simple error that Gross appears to have made was that he confused stock appreciation with stock returns (appreciation and dividends). While stock prices cannot indefinitely appreciate at such a rate (and have not done so over the past century), stocks can, theoretically, provide 6.6% real returns indefinitely (even with no GDP growth). To illustrate, let's assume that real GDP permanently stagnates, causing real earnings and stock prices to also freeze, and we go into an indefinite period of no inflation (so earnings and share prices stay constant in real and nominal terms).

In such a scenario, stocks (using the S&P 500 as a proxy) could still deliver returns of 7.7% -- even with zero GDP growth. That's because, at an estimated price/earnings ratio of 13 times (for the S&P 500 (SPY)), companies are providing a 7.7% earnings yield. Those earnings get paid out to investors in dividends and/or add to retained earnings, book equity, and the company's valuation -- whichever way, adding to annual returns.

In other words, absent all growth factors, you would get a 7.7% real return from existing earnings yields, alone. To maintain such a yield, over time, everything just needs to stay constant -- assuming earnings are paid out as dividends and/or retained and invested to provide a return comparable to the earnings yield.

Henry Blodget did a great job, recently, of pointing out some of the flaws in Gross' logic. In doing so, however, I believe that he also made some errors of his own. Blodget stated that he, also, believes that future stock returns will be somewhat lower than the historic norms -- not for the GDP-based reasons that Gross gave, but because cyclically adjusted P/E ratios are historically high and dividend payout ratios are historically low.

Now, I am not a believer in using cyclically adjusted P/E ratios, but I'll leave that debate for another day. With respect to the dividend yields, I see no reason why a lower payout ratio (in theory) should negatively impact returns -- unless Blodget has a crystal ball that tells him that future returns on retained earnings (i.e. earnings not returned as dividends) will be sub-par.

With retained earnings, there are examples where shareholders don't benefit commensurately with the amount earned and retained (e.g. when they are used for poor investments), as well as cases where they benefit much more (e.g. re-investment for high-growth/no-dividend companies; like Apple (AAPL) over the past 5 years). In general, I believe that companies do a pretty good job of efficiently allocating earnings (paying them out as dividends unless there are good investment opportunities on which to spend).

Therefore, I see no reason to believe that retained earnings, in aggregate, benefit shareholders any more or any less than earnings returned to shareholders as dividends. As such, I would assume similar returns, regardless of dividend payout ratios over the near-term.

This brings up an interesting question. What if all companies suddenly paid no dividends and indefinitely re-invested their earnings back into in their businesses? In such a scenario, could stocks still provide real returns that systematically outpace real GDP growth over long periods -- as all of the returns would then be from price appreciation and none from dividends?

I believe that the short answer is no. As public companies' share of total wealth increased at higher-than GDP rates, eventually, there wouldn't be enough attractive investment opportunities providing returns above real GDP growth. At that point, if companies could not then switch over to paying dividends, I would expect that returns would eventually have to fall to levels more commensurate with GDP growth. To be clear, that is NOT to say that investment opportunities, CURRENTLY, are insufficient to justify the existing (historically low) dividend payout ratios.

In conclusion, in a no-dividend-scenario, over very long periods, Gross could be right -- but that is not the reality and never will be. Companies can and will pay dividends. Going forward, Gross' conclusions could prove to be correct and the next century may provide returns below those of the last century, but not for the flawed reasons that he gave. I find it very interesting how such a simple analytical error slipped past Gross, who is a brilliant man with an admirable track record. It seems that this is just another example that illustrates that we're all human.

Disclosure: I am long AAPL, SPY.