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Wall Street Exposed (Part 1): The Almost Worthless Stock Market

|Includes: DIA, QQQ, SPDR S&P 500 Trust ETF (SPY)

What sort of anti-capitalist ignoramus would have the audacity to say the stock market is almost worthless? Equity investing is one of the leading methods for building long-term wealth and it continues to thrive and survive the test of time. But notice I did not say it was worthless, I said it was almost worthless. My reasons for stating this has little to do with the amount of historical or potential of wealth creation. Let me explain…

(This is the first part in a series of articles that will be published on Portfolio Cafe's website where I create investment models and syndicated here on my Seeking Alpha blog)

The Stock Market Food Court

To highlight my point, I would like to tell you a little story about hungry people going to a large food court. The hungry individuals walk around eyeing out all the delicious food from every walk of life trying to decide which meal is worth their hard-earned dollars. One customer is about to order a slice of pepperoni pizza when he notices a membership card that promises something even better - ownership in the pizza company. After forking out a hefty sum and acquiring 10% ownership the man goes up to the counter and asks for his rightful share of the pizza rotating on a pie plate behind the glass.

"We cannot give you any food sir," the server politely responds, "as your ownership of the company does not entitle you to free products." The new equity owner tries to reason with the man that he is entitled to 10% of the company which should include 10% of all the pizza being made. But the company will not part with their food.

  • "Sir, if we gave you our pizza for free - that would cut into our profits…and your profits as well."
  • "Then give me 10% of the profits which I know are mine, and I will buy the pizza with my own money."
  • "No sir," the attendant insists, "you do not get 10% of the profits either. We need those profits to grow the business much bigger. But don't worry, your 10% will be worth much more in the future."
  • "And then can I give you my 10% equity stake for 10% of the business which should be worth a whole lot more?"
  • "You just don't understand sir. It doesn't work like that. You will never be entitled to anything from the business. Not a hat, nor a slice of pizza, nor a single dollar from the till. The owner in the back room has 51% of the company and he has no intention of giving cash back to you in any way, shape, or form. That is not our policy."

The investor scratches his head trying to figure out what exactly he just purchased. He looks at his 10% ownership card and asks...

  • "Let me get this clear. I own 10% of the company but I don't actually get anything tangible for my share. Help me out here than, how is this worth anything at all? You won't give me cash, pizza or even a job. How exactly do I make money from this so-called investment?"
  • "Sir," the server laughs, "you simply sell it to another hungry patron."
  • "And how," the investor sighs, "do I value this 10% certificate if none of us shareholders can trade it in for anything? Aside from speculatively trading it around - how do any of us convert this paper into something more than a napkin? Your company could grow twice as big and I still do not get access to the profit or the pizza."
  • "Now you get it sir. But try to downplay that when asking for more money for your equity stake. Instead you should focus on the growing profit that you are not entitled to and how much pizza our customers are eating despite you getting none. Sidetrack them with our new pizza offerings, our drink combos, and the potential for new stores to open but I discourage you from discussing the what the equity stake is really worth. Just keep passing it around with a good story and you should do okay after many years. Who day we might pay a portion of the profits back...but then again maybe not. We will decide much later."

The Intangible Stock Market

And so it goes with the stock market. The point is - unless a company pays back profit in the form of a dividend to the shareholder - the stock market has no intrinsic value and is 100% speculation. Shares mean ownership but have you ever tried to redeem your shares at the company for a vehicle, computer or cash in the vault? It won't happen. There is a big disconnect between the firm and your piece of paper stating partial ownership. Your only option is going to the open market and trying to sell your virtually worthless piece of paper to another hungry investor who also cannot cash in his stake to the company. The only real method to extract tangible value back into your pocket is through dividends - everything else is fantasy and speculation.

But, you may contend, what about intrinsic value such as cash per share and earnings per share? What about book value per share? Okay, let's walk through a scenario where the company refuses to pay dividends and see how much intrinsic value you really have.

A company (and this is a real company) earns almost $8 per share in revenue. The company is earning over $2 per share in profit. They are holding almost $2 per share in cash. Would you believe me if I said that the company was trading at 4 cents per share?

Regardless of how crooked this company may or may not be - if they were paying a dividend of even 10% of profit generated this would be a much different story. But where there is a big disconnect between the firm and shareholders, the shares are virtually worthless as you cannot extract value from the company despite being a shareholder - and nobody wants your shares since they cannot extract value either.

This also works the other way. A company reports big growth numbers and the firm is expanding so investors will pay each other more and more for the shares. But unless dividends are paid out at some future date, what value do the shares have? What exactly are you entitled to with these shares other than selling them to another speculator that has the same difficulty in determining value?

Powerful Shareholders Can Force the Issue

Without dividends, or at least the threat of dividends - the stock market is virtually worthless. Granted, if insiders held less than 50% of the company there is the potential of a hostile takeover where the new owners could extract the value. If a majority of voting shareholders got together they might be able to make changes. But how often do you see shareholders banding together and raiding the vaults to get some value back? Most shareholders follow the advice of Warren Buffett and avoid dividends. They view the returning of profits as a weakness that the company has nothing better to do than give the money back to shareholders which have the burden of paying tax and re-investing. But they miss the point that without dividends the share prices may just as well be $1 as it could be $1 million per share. And even if the majority of voting shareholders forced the issue, how far would share prices fall as the company is broken up into liquidation value? And if this process was repeated across the entire market thus killing the economy -who would be buying the liquidated assets?

I go back to my original statement that dividends - or the threat of dividends - is what gives some semblance of sanity to the stock market. If dividends were illegal, the market would be almost worthless and impossible to value or gain value from. A price to earnings ratio of 1 or 1,000 makes no difference unless you can somehow access the earnings at some future date. Book value only matters if you have the power to force liquidation and divide the cash. Anything intangible to the shareholder carries no real may as well value the company by a multiple of oak trees on headquarter property. Let me be clear that I am not saying that you cannot make money from the stock market or that it has no value...what I am driving at is why shares are so difficult to value and am hinting that there are other forces driving the market other than efficient and rational markets. If valuation (focus is on non-dividend stocks) is difficult to impossible by almost any ratio, just how is the average investor deciding what a fair price is? Fair compared to what...what he can sell it to another speculator for? And what tangibles that the shareholder has access to is that based on? Round and round we go.

Prepare For the Next Revelation

So we have discussed that, at least on a conceptual level, the market needs to offer investors an exit strategy other than simply forcing participants to pass a stock certificate - virtual or otherwise - back and forth while guessing what sort of theoretical value it may have. To link firm value to equity value there needs to be a vehicle to transport company worth into the certificate - or else it is impossible to prove intrinsic worth.

Part 2 of this series will expose another Wall Street myth...are share buybacks good for shareholders? Does it return shareholder value much like dividends? What is the truth that companies are not telling you?