Bull!

by Maggie Mahar

  But not all hard assets are created equal. U.S. real estate made Faber (and many others) uneasy because it sat on a mountain of mortgage debt.49 Granted, real estate is always a local story: in cities like Manhattan, the prices of luxury condominiums had reached such frantic heights that apartments might better have been priced by the square inch rather than the square foot. Granted, in other markets, reasonable values still could be found, but much depended on interest rates. If rates rose, real estate prices would, all but inevitably, fall. In the end, for an individual investor, everything turned on the particular property, its location, how long he intended to hold it, and its “use value,” not just as an investment but as a home.

  For an investor looking for a home for his money, however, gold seemed to many the safe harbor of choice. Historically, when investors have lost faith that paper assets will hold their value (whether stock certificates or paper currencies), gold has provided shelter. For example, “during the Great Depression, Homestake Mining rose from $65 in 1929, to a high of $544 in 1936. Homestake also paid $171 in dividends—which was more than twice the price of its stock in 1929,” Marc Faber pointed out. During the seventies, gold once again soared.50

  Still, even those who were most bullish about the long term did not pretend to forecast the short term. Faber feared that speculators might push gold into a Nasdaq-like bubble, which would then blow off. Richard Russell remained convinced that a long-term secular bull market in gold had begun, but over the short term, he anticipated a series of cyclical bear markets.

  EMERGING MARKETS

  In 2003, price/earnings ratios suggested that U.S. stocks were not cheap. By contrast, P/Es in Asia had not yet recovered from the ’97 crash. “Here, in Thailand, many companies trade between 5 and 10 times earnings and pay a dividend of 7%,” Faber reported. “You can buy companies at or below book value in Thailand, Indonesia, and the Philippines.”51

  Gail Dudack agreed, suggesting that the prospects for growth looked better in the emerging markets than in the United States. “China, Thailand, Indonesia, Malaysia, Singapore, the Philippines, Australia, maybe some Middle Eastern countries—investors would be wise to find exposure to these parts of the world,” she said in the summer of 2003. “But an investor should be aware that bubbles could form there over the next five years, as well.”52

  An investor who wanted to place a bet on both commodities and emerging markets might do well to look at some of China’s neighbors, Marc Faber suggested. “For most Asian countries, exports to China are more important than exports to the U.S.,” he explained. As China’s industrial base expands, so does its demand not only for oil but for raw materials such as copper and iron ore. Meanwhile, as China’s middle class grows, so does the market for food, fiber, energy, and precious metals. “Neighbors in Southeast Asia are likely to profit from China’s expanding economy,” said Faber, “along with resource-rich countries like Australia, New Zealand and Russia.”53

  Lee R. Thomas III, Pimco’s global bond strategist, suggested that investors step back and consider global demographic trends. On the one hand, aging populations in the United States and Europe need to save more, Lee observed in June of 2003. The long bull market in stocks had only masked “a looming pension crisis.” By 2003, the need for increased saving was apparent, but “the key economic problem of the next decade will be how to recycle increasing saving into profitable capital spending projects,” Thomas declared (emphasis mine).

  In a post-bubble world “low growth, low inflation, and low interest rates” are all but inevitable, he argued, leading to low real returns for both stocks and bonds. “What is the solution if Japan, the U.S., and Europe all need to save more, but it is getting hard to find places to invest all this savings?” he asked. “The answer is to invest elsewhere, in the parts of the world where capital is still scarce, and where populations are still young. During the 18th century, the advice to anyone seeking to grow his wealth was, ‘Go west, young man.’ Today the advice a western investor should heed is, ‘Go east, young man (or woman).’ Or, perhaps, ‘Go south.’ Go anywhere capital still is scarce and prospective real returns remain high. Invest in the emerging markets.”54

  INCOME: “THE ROYAL ROAD TO RICHES”

  Finally, if there was one new investment theme that stood out at the beginning of the 21st century, it was a desire for dividends.

  “What is rare is always most valuable,” Maureen Allyn, Scudder’s former chief economist, remarked in 2003, “and what is rare now is income.”55

  During the Great Bull Market of 1982–99, dividends fell out of fashion. Indeed, they began to look decidedly dowdy. Who cared about a 5 percent dividend when capital gains of 15 to 20 percent were all but guaranteed? In the past, investors cherished their dividends; after all, they accounted for half of the stock market’s returns from 1926 through 1981. Without them an equity investor would have lost money in more than a third of those 56 years.

  But as Act III of the bull market began in 1995, all eyes were focused on capital gains. From the fall of 1996 through the fall of 2001, only 1.5 percent of the S&P 500’s 10.1 percent average annual return came from dividends.

  Companies were not paying dividends for a simple reason: they didn’t have to. “There was no pressure from shareholders,” observed Jim Floyd, a senior analyst at Leuthold’s firm. Even when bonds were paying 6 percent, stocks were able to compete on capital gains alone. Investors new to the market knew little about the history of dividends—or how important they were to supporting the mythology that surrounded “stocks for the long run.”

  In the late nineties, investors did not just ignore dividends, they shunned companies that paid them. If a corporation lifed its dividend, its share price might well fall. In a corporate culture hooked on growth, sharing earnings with investors was seen as a sign of weakness. The conventional wisdom had it that if a company’s managers were on the ball, they could earn far more by retaining profits and plowing them back into the business.

  By 2003, however, the times were changing. In February, when Goodyear announced that it was dropping its dividend, the company’s share price plunged by 17 percent. The loss of the dividend was not the only reason shareholders dropped the stock (sales of the tires also had something to do with it), but the sharp reaction indicated that they were not pleased.56 “Dividends are going to come back,” said Ralph Wanger. “Shareholders are going to say, ‘You know you talked us into keeping the money in the company—you said you had great investment opportunities and we’d all be better off. And you deceived us. Half of the money you wasted making acquisitions at ridiculous prices and building factories for products that never got made, the other half you stole—awarding yourself stock options and writing yourself checks.’

  “Earnings are an accounting theory,” Wanger declared, “and dividends are cash flow.”

  Certainly, Wanger was right about earnings being theoretical: in the aftermath of the bubble, there were so many theories about how to count them that no one was entirely certain just how profitable some of the nation’s largest corporations were. This is the problem with capital gains—they are gains only on paper, unless and until an investor sells his shares. “Today’s [low] dividend yield puts investors totally at the mercy of one another—what John von Neumann characterized as ‘combat and competition,’” Peter Bernstein observed at the end of 2001. “When cash flow is a trickle, the investor cannot obtain cash, for any purpose, without finding a buyer [for his stocks]. The buyer may or may not be there when needed. The price the buyer is willing to pay may or may not provide the total return the investor originally expected. Investments without cash flows are risky, uncertain.”57

  Unlike earnings, dividends are forever; they can never be restated. “Dividends also demonstrate that management has enough confidence in the firm’s future to part with some cash,” Haywood Kelly, Morningstar’s editor in chief, observed. “This is why, historically, even though dividends per se do not increase the value of a firm, sto
cks have tended to rise when companies boost their dividends. The market senses that insiders—those who know the company best—are bullish on its prospects. Moreover, a high yield relative to other stocks suggests that shares are cheap.”58

  BEWARE OF COMMON STOCKS BEARING GIFTS

  But in the early years of the 21st century, common stocks did not appear to be the best place to search for dividends. First, few companies paid a decent dividend. Secondly, as noted, in 2003 share prices remained relatively rich; another leg down in the bear market and capital losses could cancel several years of dividends. Finally, by 2003, corporate accounting had been so confused and so corrupted that it was not clear how many companies could afford to pay a dividend—or raise it—even if they wanted to.

  By 2002, corporate debt stood at “six times earnings for U.S. stocks—the highest level in more than 40 years,” GMO’s Jeremy Grantham observed.59 If interest rates remained low, most would be able to handle the debt service. But that remained an uneasy “if.”

  This was just one reason why investors hungry for dividends would do well to take a close look at a corporation’s balance sheet before buying shares in a company that promised income, warned Kurt Richebächer, editor of The Richebächer Letter. By this reckoning, “in 1997, non-financial corporations paid $218.1 billion in dividends from $337.7 billion in after-tax profits.” All well and fine. “But five years later, they were paying dividends of $258.8 billion compared to profits of only $197 billion.”

  “This meant that U.S. companies have been financing their dividends by either drawing down their cash reserves or borrowing,” observed Marc Faber, citing Richebächer’s numbers. In many cases, “soaring depreciation charges are creating the cash flow for dividends,” Faber explained. “But when you depreciate $100 million worth of assets that are becoming obsolete and need replacement, you are supposed to be making a $100 million investment in new equipment.” In 2002, however, capital spending was declining. “A company might depreciate something by $100 million and spend $40 million, using the rest for dividends”—creating the impression that the corporation was far wealthier than, in fact, it was.60

  Of course, some companies paid a reliable and decent dividend. But for some investors, preferred stock might be a better choice. Not only do preferred shares pay a dividend, they also tend to be less volatile than common shares—an appealing advantage if an investor is dipping one toe into a new class of assets.

  Pros like Gail Dudack, Richard Russell, and Martin Barnes also favored AA corporate bonds, highly rated municipal bonds, real estate investment trusts (REITs), and foreign government bonds—but only if an investor was able to buy them at a reasonable price. By the summer of 2003, high-yield emerging market bonds, for instance, had just completed a giddy run. In many cases, highly rated bonds of U.S. corporations also looked pricey—though a tax law passed in 2003 cut taxes on those dividends, adding to their allure. (The tax break also applied to some, but not all, preferred stocks.)

  THE MIRACLE OF COMPOUNDING

  To an investor accustomed to the returns of a bull market, the idea of collecting 4 or 5 percent a year might well sound boring—and so it is, Richard Russell acknowledged, “until (after seven or eight years) when the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!”

  Most investors have seen compounding tables that show how, over time, interest or dividends build wealth. (Boiling those tables down to a rule of thumb, “the rule of 72” says that 72, divided by an investor’s total return, tells him how long it will take for compounding to double his savings. For instance, if an investor earns capital gains of 3 percent and dividends of 5 percent for a total return of 8 percent, his money will double in nine years.)

  In 50-odd years of investing Richard Russell had never bought a stock that did not pay a dividend. Russell called compounding “The Royal Road to Riches,” in part because this is the route that “Old Money” has always taken. “In the investment world, the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader,” he declared. “The advantage that the wealthy investor enjoys is that HE DOESN’T NEED THE MARKETS, because he already has all the income he needs. He has money coming in via bonds, T-bills, money market funds, stocks and real estate. In other words, the wealthy investor never feels pressured to ‘make money’ in the market.”

  If an investor is paid while he waits for a new secular bull market to begin, he is less likely to make costly mistakes. He can afford to be patient: “When bonds are cheap and bond yields are irresistibly high, the wealthy man buys bonds,” Russell explained. “When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the ‘give away’ table, he buys art or diamonds or gold.”

  And, if no outstanding values are available, the rich man sits on his hands. “Periods of inactivity” can be painful, as Warren Buffett acknowledged in the spring of 2003, but not nearly as painful as watching savings evaporate.

  Ultimately, Russell’s point was this: the poor man can become the wealthy man if he behaves as if he is already wealthy, scorning investments that do not provide income. The only exception is a situation that offers “safety, an attractive return, and a good chance of appreciating in price,” said Russell, setting a high bar. “At all other times,” he counseled his readers, “the compounding route is safer and probably a lot more profitable, at least in the long run.”61

  TIPS

  Unfortunately, even the “miracle” of compounding is another one of those pieces of conventional wisdom that work only in certain seasons. In a period when inflation averages 7.7 percent a year (as it did in the seventies), an investor who holds on to an investment paying 5 percent loses 2.7 percent a year.

  By contrast, in an era when inflation hovers between 1 and 2 percent (as it did in 2003), a decent dividend makes all the difference. If an investor is saving for retirement, all that matters is the “real return” on his savings, after inflation. His only concern is not how much money he will have but how much that money will be worth. If an investor could stay, say, 2 to 3 percent ahead of inflation on every penny he saved over a lifetime, he would do very well.

  Unfortunately, in 2003 virtually every pundit acknowledged that inflation was not dead, merely hibernating. (The idea that we had come to the End of History came and went sometime in the nineties.) No one knew when it might return. Both reasonable and unreasonable men offered cogent and not so cogent arguments as to why inflation or deflation was more likely. Some, like Gail Dudack and Marc Faber, recognized that it would be quite possible to have both at the same time.

  Whenever inflation appears—whether in 10 months or in 10 years—it turns the “miracle” of compounding on its head. If an investor buys a security that promises to pay 5 percent a year over 10 years, and inflation rises to 6 percent, he has nothing to compound, except losses.

  There is, however, a final “alternative investment” that provides an unparalleled hedge against inflation for long-term investors. In 1997, the U.S. government created TIPS (Treasury Inflation-Protected Securities), Treasury bonds that come with insurance against rising prices.62

  Like plain-vanilla Treasuries, TIPS are backed by the federal government. When they mature, an investor can be certain of getting his principal back, plus a guaranteed fixed dividend. The difference is that TIPS also offer a buffer against inflation: each year that the dividend falls short of inflation (as measured by the consumer price index), the government pays a bonus to bridge the gap. In other words, the investor knows that his savings will always outpace inflation. His total return floats, but it cannot fall below the guaranteed yield. The fixed yield on TIPS can seem small, but with the inflation booster built in, TIPS compare favorably to other Treasuries. By 2003, TIPS had become so popular that funds investing in TIPS were soaring. For example, the
Vanguard Inflation-Protected Securities Fund boasted a total return of 16.6 percent in 2002, and 7.1 percent in the first five months of 2003.

  Because mutual funds trade TIPS, they offer the possibility of fatter returns in the form of capital gains as well as dividends. Of course, this also means the investor is exposed to capital losses—red ink that could expunge not only the dividend and the inflation bonus, but part of an investor’s principal.

  By contrast, if an investor buys TIPS directly from the government and holds until the bonds mature, he pays no fees and is certain of getting his original investment back, plus income that stays ahead of inflation. There is no credit risk and no interest-rate risk—making TIPS the only risk-free long-term investment on Wall Street.

  In an uncertain world, a risk-averse investor could hardly do better.

  A history of financial cycles cannot pretend to protect investors against losses. As everyone knows, history is a poor teacher, and human beings poor students in her classroom. Nevertheless, if one truly thought that men and women were doomed simply to repeat their mistakes, only misanthropes would write history—and only masochists would read it.

  In truth, a knowledge of history is an investor’s best defense against error. Despite all the financial engineering that attempts to eliminate risk, cycles appear to be as inevitable as the seasons. Investors who understand these cycles are more likely to survive the winter of a bear market and to avoid its final phase—despair. They know that eventually, summer always returns, and more than that, they know that somewhere on the planet it is always summer.