Wednesday, July 09, 2014

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Joe: In general, because inflation erodes the purchasing power of their returns, investors demand an inflation premium for all bonds and fixed income securities.  For U.S. Treasuries, that premium has varied from around 1% for short maturities to nearly 3% for longer maturities.  Investors have also demanded a rate of return in addition to the inflation premium.  We call that second layer of interest rates the “real” rate of return.  You can see this layering effect on the chart below, which compares the interest rate on a 10-year to the level of inflation going back to 1995.

As the chart above shows, the 10-year U.S. Treasury rate (blue line) typically stays above the inflation rate (red line).  The difference or “spread” between the two lines represents the real rate of return to investors.

Over the past 50 years, inflation has averaged just over 3% and investors in 10-year U.S. Treasury bonds have demanded about a 2.5% percent real rate of return.  Thus, 10-year U.S. Treasury bonds have averaged about 5.5% during this time.  The problem for investors is that these long-term relationships are not highly correlated, meaning both the inflation premium and the real rate of return in any given market can vary widely.  Since 1960, 10-year Treasury bond yields have been as much as 9.5% above the rate of inflation and 5% below.  Today, 10-year U.S. Treasury bonds are yielding about 2.5% and inflation is running at about 1.5%; thus, investors are only receiving a real rate of return of 1%.    

Nathan:  Why do you think investors are willing to accept such a low real rate of return?

Joe: The answer to that question can be answered in five words: slow-growth economy and Quantitative Easing. Because of the slow-growth economy, the Federal Reserve has purchased billions of dollars worth of 10 and 30-year Treasury bonds to push rates lower in order to stimulate the economy. In reality, because there is a desire for safe bonds, the Fed is forcing investors to buy an artificially low yield. For this reason, we do not consider U.S. Treasury bonds a good investment. We believe rates on U.S. Treasuries will rise gradually over the next few years. Referring back to the teeter-totter effect, that would mean that bond prices are headed downward.

Nathan: The economy has been in a slow growth environment for some time now.  If the economy begins to grow more quickly, what would be the impact on inflation and interest rates?  

Greg: That seems like a simple question, but that “if” word confuses matters dramatically.  The Federal Reserve has done everything in its power to stimulate growth and yet GDP growth has been anemic.  We are experiencing the slowest economic growth since the Great Depression of the 1930s, and we don’t think things are going to change very much in the near term.  In our judgment, until the housing industry recovers closer to its historic growth rates, the economy will stay in low gear.  Housing has a much bigger impact on the overall economy than the economic data show.  Having said that, in a faster growing economy, there is no doubt that interest rates would rise.  Surprisingly, however, we don’t believe inflation is likely to rise much in the coming years and that would mean that interest rates will stay lower than most people may now think.  The Fed knows how to control inflation, and we have no doubt they will not let it get out of control.  The Fed’s current target for inflation is in the range of 2-2.5%.  They will probably let it slide a little higher than that for a while, but not enough to cause the bond market to become panicked and send interest rates soaring.  

Nathan: Greg, as you said earlier, the Fed has effectively targeted interest rates since 2008 and in doing so through the Quantitative Easing program has amassed a balance sheet totalling more than four trillion dollars.  Isn’t the bond market at great risk as the Fed begins to unwind this huge portfolio?

Greg: The Fed did not go to all the trouble and expense to amass these bonds to throw them back on the market and undo all the good they believe the program has achieved.  Most people don’t realize that the Fed is under no mandate to unwind the portfolio.  In fact, both recent Fed Chairs, Ben Bernanke and Janet Yellen, have said they may allow the portfolio roll off by holding the assets to their stated maturity dates.  If that is the case, the impact on interest rates would be muted.

Nathan: What is DCM’s current opinion on inflation and interest rates over the next 12 months?

Joe: We expect a short-term uptick in inflation as the economy recovers from the very cold winter, but don’t believe it will stick.  We expect inflation will stay in the 1.5% to 2% range for most of the year.  The main reason we don’t believe inflation can return in any meaningful way is because wage growth remains well contained.  Since the 2008-09 subprime crisis, private employee wage growth has averaged about 2% per year.  Unless that were to push above 3% and stay there for a time, we are optimistic that inflation will remain tamed.  Wage growth is being held back by the relatively high unemployment rate, but also by the more than five million people who have stopped looking for work and are no longer in the unemployment statistics. We’re not seeing much in terms of wage growth at the moment.  The good news here is job growth, while muted, has been steadily increasing over the last nine months, except for the weather-impacted data in February.

Our 12 month forecast for interest rates is that the Fed will keep short-term interest rates about where they are.  If economic growth starts to pick up, we could see the longer-term interest rates start to move higher.  In this scenario, we would expect the 10-year U.S. Treasury to peak around the 3.5% area and only push higher from there once the Fed signals an increase in short-term rates.  Even then, we do not see 10-year bonds moving back to their long-term average yield of 5.5% for many years.  There remains too much slack in the economy to cause that to happen.

Next Time: How and Why We Emphasize Preferred Stocks in Fixed Income Portfolios

Thursday, June 19, 2014

Fixed Income, Part I: Relationship Between Interest Rates & Bond Prices

With interest rates at historic lows, and the Fed saying they will keep short rates low for an “extended time,” there is much confusion among financial pundits as to where interest rates and bond prices are headed in the coming years. With so much disagreement among the experts, many of our clients have asked that we provide an in-depth discussion of our views on inflation and interest rates, and the path these rates may follow in the coming years.

Although we regularly answer these questions in our client meetings, using our blog allows us to quickly explain our current views and strategies to a larger audience.

This particular series of blogs focuses primarily on the bond market; beginning with the basics before tackling the more complicated issues.

The format is Q&A. The first installment is a brief analysis of the fundamentals of bond investing, which we hope will build a solid foundation of understanding as we move forward. Nathan Winklepleck, co-editor of the blog, has assembled a list of our most frequently asked questions. He will serve as the moderator for the Q and A and will ask Joe Zabratanski our Senior Fixed Income Manager and Greg Donaldson our Chief Investment Officer to provide answers and commentary.

Q: Nathan: We have received several questions from clients about the impact of changing rates on bond prices.  Could you explain the relationship between interest rate fluctuations and fixed income prices?  How and why does one influence the other? 

A: Joe: The relationship between interest rates and fixed income prices is like a teeter totter.  On one side you have the bond’s price and on the other you have the bond’s yield.  One cannot go up without the other going down.  In a manner of speaking, they are “hardwired.”  

The reason they move in opposite directions has to do with a bond’s “fixed” qualities.  Most bonds have a fixed interest rate and a fixed maturity date.  Thus, when interest rates go up or down, it causes a fairly predictable change in bond prices to achieve a new equilibrium level.  Thus, it is changes in interest rates that drive bond prices, not the other way around, as so many people believe.

For example, if you were to buy a 30-year U.S. Treasury bond with a “par value” of $1,000 and an interest rate of 3.5%, you would pay $1,000 today and receive $35 per year for the next 30 years and then get your original principal back. If you are planning to hold the bond to maturity, you know on the purchase date what rate of return you will earn for the next 30 years. The question we get asked most often is:”What happens to the value of my bond if interest rates change?”  At first glance, this follows a simple formula.  
Fast-forward 3 years; let’s say interest rates on 30-year U.S. Treasury bonds have risen from 3.5% to 4.5%.  To find the price of a bond with a fixed interest rate of 3.5% in a market where new bonds are yielding 4.5%, we return to the formula and solve for the unknown price, represented by the variable X. We can do this because the other two parts of the formula are known. 
Investors are now requiring a 4.5% yield on long bonds, and we know our bond is paying $35 per year. To solve for the unknown price (X), we know from high school algebra to multiply both sides of the equation by X.  This creates a new formula:
Re-arranged, the formula becomes:

In summary, today’s 30-year bonds are yielding about 3.5%.  If interest rates were to rise by one percent over the next three years, the formula above shows that the bond’s price would fall to about $780, or nearly 22%.

Nathan: Wow, that’s quite a hit for a rather small increase in rates. I’m guessing that is the reason so many people are so confused about what to do with bonds?

Joe: Bonds are now at historically low yields, and thus, are very sensitive to changes in interest rates. But let’s remember, if we hold a bond to maturity, we will receive the full $1,000 par value, so in some way the example I just gave you is not as bad as it may seem at first glance.  The price loss the bond experiences in a rising interest rate environment is only a loss on paper, unless you were to sell it.  

Nathan: What if I said I’m going to sell the 3.5% bond and buy the 4.5% bond.  That way I can receive the new higher yield without the big paper loss on the first bond I bought?

Joe: There is nothing to be gained by doing this because; the market is very efficient in these repricings.  They happen very fast.

Nathan: In the example you provided, the bond’s maturity was 30 years in the future.  Would a bond with a shorter maturity be less volatile?

Joe: Yes, but it would also come with a heavy cost.  Today, 10-year Treasury bonds yield only about 2.5% and five year T-bonds are yielding a paltry 1.75%.

Nathan:  These low yields are just remarkable.  In the past, what have been the long-term averages yields of bonds with these maturity ranges?

Joe: 30-year T-bonds have averaged over 6%, 10-year and 5-year T-bonds have averaged 5% and 4%, respectively.

Nathan: It seems that returning to the long-term average yields would be very destructive to bond values, even if we held every bond to maturity.

Joe: Nathan, I’m going to save the strategy we are currently using in this environment for future blog discussions. Instead, let me share with you some of the general ways of diminishing risk in the fixed income market.  Earlier you asked if a bond’s volatility changed with its length of maturity.  That was a very good question, and I want to amplify my answer.
Bonds have two main risks.  The first risk is that the issuer of the bond will “default” on the loan, which means that he will be unable to make his interest payments or pay you back when your bond reaches maturity.  The second risk is that an increase in interest rates, usually driven by rising inflation concerns, will make your bond worth less than what you paid for it.

With a bond or other fixed income security, interest rate risk is measured by a term known as “duration”.  The higher the duration, the more interest rate sensitive a fixed income security will be. Using the teeter totter example, you can think of duration as the length of the bond price’s side.  

The two teeter totters above illustrate the impact duration can have on bond price volatility.  The longer the teeter totter on the duration side, the bigger of a swing bond prices will have.  Given the same increase or decrease in interest rates, a fixed income security with a longer duration will experience much greater price volatility.

The farther away a bond’s maturity, the longer its duration will be. That is why the interest rate on a 30-year U.S. Treasury is generally higher than the rate on a 10-year U.S. Treasury. Fixed income investors refer to this as the “yield curve”, which is shown below.

As you can see by the chart, the U.S. Treasury with the shortest maturity (1 month) is yielding near 0% while the Treasury with the longest maturity (30 years) is right at 3.5%. The increasing yield curve makes sense, as it indicates that investors are currently requiring more compensation for accepting a higher level of price and interest rate volatility.

Nathan: What kinds of factors go into calculating duration?

Joe: There is a subtle difference from the meaning of duration as it relates to analyzing bonds and its meaning in common mathematical use.  In the bond world, duration is actually a precise formula that tells us how volatile a bond is.  Importantly, this calculation takes into consideration the length of maturity of the bond, as well as the interest rate of the bond.

Let me give you an example.  When using a bond calculator to determine the actual volatility of the three bonds I mentioned earlier, we find that the precise level of volatility for a one percent change in yield for the 30 year bond is 19.8%, 8.8% for the 10-year bond, and 4.8% for the 5-year bond.  You can see that volatility falls dramatically as the length of maturity falls.  We still have to deal with the very low rates in shorter maturities, but that can be done with higher yielding securities in asset classes other than U.S. Treasuries.

Nathan: So you are saying that by using securities other than U.S. Treasury bonds, we can produce respectable returns with a more muted volatility?  If that is the case, then the fulcrum, or midpoint, of our teeter totter would shift its position along the board depending upon the interest rate and the length of maturity of the security in question?

Joe: That is correct.  In addition, almost all fixed income securities have a call provision that allows the issuer to pay off the bonds earlier than their maturity date.  In addition to these calls, there are mandatory sinking funds that can change the price risk of a longer bond.

I certainly do not want to say there is anything easy about investing in this bond market, but there is wiggle room here and there that we have found to provide our clients with reasonably attractive current yields and less volatility than long Treasury bonds.  

Next time we will discuss the relationship between inflation and interest rates.  Please contact us if you have any questions.

Thursday, May 22, 2014

Economic Indicators Point to Slow, Steady Growth in Economy & Stocks

We have several economic metrics that we follow very closely at DCM.  These indicators give us a peek into the health of the economy and indicate where we may be headed.  We want to share three of those indicators with you and provide an overall outlook on current U.S. economic conditions and what they might mean for the stock market for the remainder of 2014.

1. After-tax Profits

The price of the S&P 500 index (blue line/right axis) plotted against after tax profits for the entire U.S. market (red line/left axis), which is measured in trillions of dollars.

Of all the indicators we watch, this one might be the most compelling argument for the strength of U.S. corporations.  After-tax profits reached a high around $1.4 trillion in late 2006 before their sharp decline during the Great Recession of 2008-09.  Today’s levels are well above where they were pre-2008 and show no signs of slowing down.  Companies are operating with incredible efficiency.  Many of the companies we follow can produce as much or more than they did prior to the Great Recession with significantly fewer employees. While this hasn’t been good news for employment (more on that in a minute), it is very positive for corporate earnings.

About 75% of the total after-tax profits come from the companies that comprise the S&P 500 Index.  When S&P 500 prices diverge either up or down from after-tax profits, it has a significant message as to the overall value of the market.  It is clear that there is no divergence at present.  Profits and prices have moved in line since 2009.  In our mind, this is further proof that the market is about fairly valued.  Despite the strong performance of stocks in 2013, prices have not run above the underlying company earnings.

2. Employment Is Improving

The government’s weekly report of unemployment insurance claims (blue line/right axis) measured in thousands compared to the unemployment rate percentage (red line/left axis). 

While lean head counts may be good for corporate profitability, it’s been a major headwind for employment.  Prior to 2008, the unemployment rate was hovering around 5%.  Since then, the U.S. economy has had a very difficult time adding new jobs.  After peaking in 2010, the unemployment rate has steadily fallen, but has not come near where it was before the Great Recession.  Even more concerning was the duration of unemployment.  The longer a person goes without finding a job, the less qualified they become as their skills diminish.  Long-term unemployment is a problem because it destroys aggregate productivity and causes the long-term unemployed to give up their search for work.

While employment continues to be a headwind to economic growth, the picture is improving.  The unemployment rate has fallen from over 8% in 2012 to below 6.5% today.  There are many who claim that discouraged people leaving the workforce have artificially distorted the unemployment numbers.  Our research also indicates that those who have gone to the sidelines have had a positive impact on the unemployment numbers.  However, the other employment data we watch supports the falling unemployment rate.  As the chart shows, initial unemployment claims have fallen in a virtually linear fashion since 2010.  Furthermore, the underlying employment numbers have improved greatly – even over the past 12 months.  From April 2013 to April 2014, the percentage of the long-term unemployed has fallen from 54.3% to 50.9%, while the percentage of unemployed less than 5 weeks has increased from 21.4% to 25%.

As a whole, the employment data indicates that more Americans are finding and keeping their jobs.  Those who are unemployed have spent less time without a job and it appears to be taking fewer weeks to find new work. Employment is improving, which is a very good sign for the economy. 

3. Inflation Is (Almost) Here 

The Bureau of Labor Statistic’s monthly calculation of Core CPI (red line) and CPI (blue line).  CPI measures the change in prices of a basket of around 80,000 goods and services.  Core CPI excludes food and energy prices (which tend to be more volatile) from the measurement. 

Since the Federal Reserve began their Quantitative Easing (QE) program, there has been a great deal of concern that inflation would ramp up.  The exact opposite has been the case.  As the chart shows, core inflation (red line) has fallen from 2.5% in mid-2012 down to levels near 1.5% in 2013.  Inflationary concerns shifted from too high to too low.  Recent fears about deflation in the U.S. have caused concerns among investors.

Deflation is bad for the economy because it makes sitting on cash profitable, which discourages both spending and borrowing.  When the price of goods or services will be less tomorrow than they are today, consumers benefit by delaying consumption.  This delayed consumption leads to the dreaded “deflationary trap” as falling consumption lowers demand and keeps prices falling, which leads to still lower consumption.

Since the end of 2013, deflationary fears have been muted by the modest uptick in inflation.  A healthy level of inflation is helpful for corporate profits because it allows for increased pricing power.  While the economy is still a ways away from the Fed’s target core inflation rate of 2.5%, things are starting to move in the right direction.  If the trend continues, it will have a positive impact on both company earnings and investor confidence.

What Does It Mean for the Stock Market?

The improving state of the economy coupled with continued low interest rates, decreasing uncertainty surrounding the Fed’s tapering of QE, and reduced fears about deflation has been steadily building the case for stocks to continue their upward climb in 2014.  The pause in prices so far has been good for the long-term health of the bull market.  We expect economic data to continue to be muddied until mid-to-late 2014, but we believe the economy is getting stronger.  Once investors can see things more clearly, we expect companies, especially those with visible earnings growth, to be rewarded.  

Tuesday, May 13, 2014

John Burr Williams and Chickens For Their Eggs

This is the third blog in a series exploring the theories of John Burr Williams. You can read the first post here and second post here.

In Part I of this series, we quoted Arnold Bernhard, founder of the Value-Line Investment Survey, as being an early advocate of the theories of John Burr Williams.  He agreed entirely with Mr. Williams’ belief that investors needed a generally accepted valuation criteria. He also joined Williams in warning that the effects of not having such a methodology had resulted in excess stock market and economic volatility over the years that had damaged investor confidence not only in the stock market but also in the free markets.
Bernhard boldly stated,
“In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock.  Whenever, over a period of years, the dividend or the ability to pay dividends, went up; so too did the price of the stock.  When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.”  
In applauding John Burr Williams’ theory; however, Bernhard inserted a subtle twist to Mr. Williams’ basic premise by adding the words, “ . . . or the ability to pay dividends.”  By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value.

Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist.  He is famous for saying that investing is easy: 
“Just buy wonderful companies at good to great prices.”
When asked to explain what good to great prices mean, he credits John Burr Williams’ formula for intrinsic value, but defines it with a different twist: 
“The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.”  
Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings.  Neither Buffett nor Bernhard, nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said.  
Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his book a section titled “A Chapter for Skeptics.”  There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company.  Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following:
“Earnings are a means to an end, and the means should not be mistaken for the ends.  In short, a stock is worth only what you can get out of it.”  
 He then added the following poem:
Even so, the old farmer said to his son: 
A cow for her milk, A hen for her eggs, 
And a stock, by heck, for its dividends.
An orchard for fruit, Bees for their honey, 
And stocks, besides, for their dividends.  
"The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.”  

In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets.  Williams answered this issue with the following statement, 
“The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading; and dividends for years to come, not income for the moment only.”  
John Burr Williams struck a bright line between being in the chicken business and being in the egg business.  
He believed that buying and selling chickens was a commodity decision and thus, speculation.  On the other hand, investing in egg-laying chickens was completely different.  It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.

John Burr Williams' hopes that a methodology could be agreed upon by investors to measure the long-term value of a company and not its short-term popularity still has not been achieved. There is no clearer evidence of that than the stock market's crash in 2008-09. As we discussed in Part II of this series, dividends were clearly the best indicator of value during the Great Recession. From peak to trough, both prices and earnings fell by more than 50%, while dividends only dropped by 15%.  

It is important to remember that dividends are decided entirely by the Board of Directors, who have a much clearer idea of what's going on in their particular company. They saw that 2008-09 was going to be a difficult time, but not completely devastating to their companies. If they thought things were going to be as bad as the news indicated, companies would have slashed dividends by 50% or more, but they didn't.  

Of the 30 companies that we owned in Cornerstone going into the bear market, 20 of the 30 actually raised their dividend, while 5 kept it the same and another 5 cut it. That was one of the strongest signals to us that the sell-off was way overdone and presented one of the best buying opportunities we've ever seen.

Since 2009, dividends have gained in popularity. However, most still do not fully understand the predictive power of the dividend or how to value a company the way John Burr Williams defined it. To those investors who do know how to value dividend paying stocks, the extreme volatility of the market creates many opportunities.

Next Time: John Burr Williams' Ideas About Taxes and Socialism

Thursday, April 24, 2014

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  Williams postulated that investors’ inability to properly value stocks increasingly led them to become speculators. Most people would not admit that they were speculators, but it was clear by their decisions that they were not appraising the intrinsic value of companies but betting that they knew something that the market did not.  

In one of Williams’ most insightful observations, he makes the following statement:

“To gain by speculation, a speculator must be able to foresee price changes.  Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion.  Successful speculation consists in just this.  It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . .  Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in.  How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment.  Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news.  There are two ways to do this: either cheat in the matter, or study the forces at work.  Cheating has been outlawed, so far as can be, by the Security Act of 1934.  The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ’coming events cast their shadows before.’  But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator.  Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late.  That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever.  Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.”

John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).”

As an affirmation of Williams’ theories about intrinsic value and speculation, let’s look at the Great Recession of 2008-2009. From peak to trough, both price and earnings of the Dow Jones Industrial Average fell by just over 50%, while dividends fell by only about 15%.

John Burr Williams would point to the relative minor dividend cuts as the reality of what should have happened in the stock price pull back. In essence, many investors were looking at either earnings or prices as the indicator of value, which turned out to be dead wrong.

If corporate America believed that things were as bad as many speculators did, they would have cut dividends more in line with the 50%+ fall in earnings. That did not happen, and the massive sell-off provided one of the best buying opportunities in our lifetimes. Investors who focused on dividends rather than earnings and prices were able to profit from it.

Williams extolled the virtues of a long-term view of the investment markets.  He believed profitable investing could best be assured by focusing on the long-term growth rate of dividends.  How right he was.  Since 1960, the annual price growth of the Dow Jones Industrials has averaged about 5.9%.  That figure is remarkably similar to the average annual growth rate of dividends of near 5.6%.  While these growth rates are very similar, they do not move in a “tit for tat” manner.  Dividend growth over the years has been fairly consistent, while stock price growth has been very volatile.  But, on average, every two to three years they converge.

Market volatility is frightening for many, but long-term dividend investors should celebrate it.  Large discrepancies between prices and dividends represent clear buying or selling signals.  As John Burr Williams predicted in 1938 and a half a century of evidence shows, prices and dividends always converge. Long-term investors who focus on the dividend are not only able to avoid market irrationality, but profit from it.

Next time in a blog entitled, “Chickens for Their Eggs,” we will share why John Burr Williams believed that dividends alone should be the guide to intrinsic value.

Wednesday, April 02, 2014

ABCs of Dividend Investing: John Burr Williams, The Father of Dividend Investing Still Speaks

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, The Theory of Investment Value, and it remains so today.

This is Part I of a series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories on economic growth matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: 
“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”
Mr. Williams’ dissertation did not immediately earn him his doctorate.  That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only a fool would sell his doctoral thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible.  Since he had come for the knowledge and not the degree, and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method for determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the New Deal programs of President Franklin Roosevelt.  Williams devoted an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’ teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks had enough significance to justify a doctorate in economics from Harvard.  After a heated debate, he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting.  That has certainly been the case with John Burr Williams’ theory.  What had angered his Harvard professors, at first, caused Wall Street brokers to scoff.  The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product.  Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandi

Blaming Wall Street 

A closer reading of the book, however, turned Wall Street’s ridicule to scorn.  The ways of Wall Street were being blamed, at least partly, for the stock market crash.  Williams' thesis stated the following: 

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long-run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his book, The Evaluation of Common Stocks, and echoed his concerns, 
“Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

Myron Gordon in his 1959 book, Dividends, Earnings, and Stocks Prices, pays tribute to Mr. Williams for his pioneering work in discovering methods of calculating the intrinsic value using the dividend.  Mr. Gordon would later win a Nobel Prize for his expansion of John Burr Williams' ground breaking work.  There are many academics, as well as, investment professionals who believe that Mr. Williams' work also deserved a Nobel prize.

John Burr Williams is called the "father of dividend investing," but he was much more than that.  Williams recognized that the erratic behavior of stock prices was caused by a lack of connection to the true, fundamental value.  He was one of the first people to quantify the intrinsic value of a company.    

John Burr Williams' theories are the foundation upon which we have built our Rising Dividend Investing strategy.  Over the last 20 years of employing his ideas, we have seen time and again that prices for individual stocks and the market as a whole are often disconnected from what is later shown to be their true intrinsic value.  

Next time, we will discuss Williams' views on investing versus speculating.  

Monday, March 24, 2014

Hot News Comes and Goes, But Dividends Are Forever . . .

Investors are constantly inundated with the latest regional conflict, political debate, economic data and interest rate predictions. All of this information represents the collective viewpoint or “consensus” of investors at any given point in time.

Over the many years we have spent studying the markets, the truest thing we know is that the consensus is already priced into the market... and the consensus is almost always wrong. If an investor believes the economy and earnings will be better in the future, they will “vote” with their money. In aggregate, all of those votes create the price level for a particular stock. If the consensus comes true, you won’t see much of a change in the markets and prices will generally drift sideways.

What changes the price of stocks are the things that the consensus doesn’t already expect. Therefore, the only way to make excess risk-adjusted returns is either:

1) Find where the consensus is wrong.
2) Look outside the box.