If you are a long-term investor, holding your retirement nest egg in a diversified portfolio of US stocks, perhaps in an IRA or 401(k) plan, experts and the facts now suggest that your retirement assets are probably substantially over-valued in today’s stock market.

Many equity investors are not nearly as well off as they think — unless they are in the process of selling out today to invest in fixed income securities and a widely diversified portfolio of real estate income properties.

The question that long-term investors should be asking is how much do they risk losing by continuing to believe in the Common Stock Legend and the advice of their stockbrokers?

In the roar of Wall Street cheering about good times for equities, the chances that most equity holders will ask sensible questions about market values in time to save their assets is remote.

And, if and when they should ask, it will certainly be too late, because stock markets are not designed to withstand a rush for the exits.

Quantifying the downside risk in equities

It is possible to find serious researchers at prestigious universities and financial experts with articles in the Financial Analysts Journal that state that a fall of 30% to 50% from current market levels would be required for US equities to be ‘fairly priced’.

This means that that wealth held in US equities is probably over-valued by $3.3 trillion to $5.5 trillion! A readjustment to fair value would be painful, with serious economic and political consequences.

See: “Are GAO Projected Returns on Equities Reasonable?“

Most investors do not have the time, inclination, or skills to plow through the technical literature to find out whether stocks are over-priced. And the SEC will not help them.

However, investors do not need to rely on articles in Money magazine (supported by ads of Wall Street firms), or the Quicken ‘retirement planner’ (based on assumptions that the past predicts the future), or even on their stockbrokers (who earn a living by selling common stock and equity mutual funds).

By using common sense and some easily available statistics, John Burr Williams’ famous formula for equity valuation allows investors to check for themselves whether US equities, in general, are fairly priced or not.

As John Burr Williams pointed out seventy years ago, the sensible reason for long-term investors to hold common stocks is to receive a future stream of dividends paid by the company.

To build up wealth for their retirement, investors should put aside enough current income to provide for their old age, reinvesting dividends and interest received in the interim.

A prudent retirement plan: the essentials

No one can predict what the marketplace may be willing to pay for equities twenty or thirty years from now, when today’s retirees will need to sell investments.

However, with the anticipated crush of Baby Boomers needing money for assisted living and health care ten to twenty years from now, chances are good that ‘reinvesting unrealized capital gains’ in the hope of selling out many years from now is, at the very least, unwise.

A sound retirement portfolio is one that will throw off a dependable stream of cash dividends and interest, not only to provide income decades from now, but also to provide substantial current yields at that distant date so as to ensure that the value of a retirement portfolio is supported by cash payouts, so that, if it is necessary to draw down on the principal, the portfolio will be fully valued by the market.

Why US equities are 40% over-valued today

Here is how an investor might evaluate the level of US equity prices, based on John Burr Williams’ formula:

 

Input values of formula	Value
G= Dividend growth rate (based on S&P 500 dividends for period 1985-2006)	5.5%
I= Typical expected return for equity investments by American retirees	8.0%
John Burr Williams’ formula for evaluating one dollar of dividends	D/(I-G)
What current dividend yield should be, based on John Burr Williams’ formula	2.5%
Actual current dividend yield, based on S&P 500 (2006) stocks	1.77%
Market fall required to adjust S&P 500 current dividend yield to 2.5%	29.2%

See “The Value of Dividends” for an explanation of John Burr Williams’ formula.

 

In other words, given the S&P 500 rate of growth of dividends on US equities over the last twenty years, and popular expectations of return from long-term portfolios of common stocks (about 8%), equities, on average, seem to be over-priced by about 40% based on the current value of reasonable expectations of the future stream of dividends.

Considering that the annual growth of before tax US corporate profits over the long-term (1946-2003) was only 5.3%, predicting growth of corporate dividends at 5.5%, based on the S&P 500 dividends from 1985 to 2006, certainly does not seem to be overly-conservative.

So the two numbers needed for John Burr Williams’ equation, the 8% return expectation of investors and a 5.5% growth rate for dividends, seem to be quite reasonable.

Therefore, a drop of about 30% in stock prices would be required for equity investors to get the 8% return most expect when planning to fund retirement goals.

Corporate reform could dramatically improve equity values

Although, as indicated in the article “US Equities: Wildly Over-Priced or a Great Bargain?“, corporate earnings before buybacks are soaring to record levels, a huge multi-billion dollar chunk of this money is being diverted to the benefit of corporate executives rather than long-term shareholders.

If Corporate America were to suddenly reform, putting brakes on executive remuneration and redirecting buyback payouts into cash dividends, paid out fairly to all investors, then, indeed, Wall Street ballyhoo would be justified. Equities would be fairly valued and ordinary investors would be adequately protected.

However, since buybacks and corporate greed seem to be embedded in Wall Street culture, any investor who is willing to bet his or her retirement comfort on a sudden change of heart and sincere reform of rapacious executives, may deserve to be taken to the cleaners.

Expect continued irrational behavior

As pointed out in a previous article, if US corporations were to change their behavior, eliminating stock buybacks and using the money instead to pay dividends fairly to all shareholders, US equities would indeed by fairly priced and most retirement plans would be on track.

However, don’t hold your breath until that happens.

Uncontrolled, self-serving behavior of corporate executives taking advantage of an accommodating and dormant SEC and the unquestioning belief of the investing masses in the Common Stock Legend suggests that current patterns are likely to persist and that, therefore, US equities will continue to be substantially over-priced — until the next crash.

Depending upon your point of view, the US stock market is either vastly over-priced, or a great bargain — and if you have a split personality, you could both be right!

This peculiar state of affairs occurs because two radically different yardsticks can be applied in measuring corporate performance: one based on an unquestioning respect for Generally Accepted Accounting Principles, and the other based on commonsense, an appreciation for cash in hand, and the time-honored principle of “what’s in it for me?”.

The key to this conundrum lies in how one views stock buybacks: Are the trillions spent on buybacks really the money of most common shareholders, or do they belong to someone else?

• If you are a long-term, buy-and-hold investor, with a portfolio made up mainly of index funds and equity mutual funds, the money that goes into stock buybacks is definitely not yours. It goes to someone else. You’ll never see a penny of it!
• If, however, you are a corporate executive with loads of stock options, or with remuneration linked to stock prices, or if you are an equity hedge-fund manager, with 20% of the profits on borrowed money and somebody else’s nickel, with no downside risk (for you), then stock buybacks are definitely to your advantage.

If you believe that GAAP profits tell the whole story, then perhaps equities are really a bargain. Don’t worry, be happy.

However, if you’re a tiny bit skeptical and are willing to look at profits with a reasonable, “what’s in it for me” philosophy, then you might start running for the hills.

Learn to Think PATAB!

You’ve probably never heard of PATAB, and that’s because it’s a term I just created. It means: profits-after-taxes-and-buybacks, as distinguished from ordinary profit-after-taxes.

This graph, using data from Federal Reserve flow of funds account F102, shows the difference between ordinary after-tax accounting profits, and PATAB:

Ordinary after-tax corporate profits, more than tripled between 2002 and Q3 2006, which suggests that everything you’ve read in the Wall Street Journal about this being ‘the best of times’ seems to be true.

However, PATAB earnings failed to recover from the doldrums of the 2000 market crash and show stagnant corporate earnings.

A Look at Price-Earnings Ratios

Another measure of equity value is the price-earnings ratio.

Using Federal Reserve flow of fund data from tables F102 and L202 (total after-tax profits and the market value of non-farm, non-financial corporate business) we see that rising accounting profits caused price-earning ratios to drop from over 40 times earnings (in the post 2000 crash years), leveling off at around fifteen times earnings — ordinarily a sign of a fairly-priced market.

However, the Price-PATAB ratio is something else again, by mid 2006 rising to levels of 50 and 60 times earnings after taxes and buybacks.

If you’re not getting any of this buyback money (you would have to have sold stocks at a handsome profit to qualify) stocks are definitely over-priced for you.

Dividend Yields and PATAB

Finally, we may also examine dividend yields, taking buybacks into consideration. If you believe that buybacks are just another form of dividends, then ‘dividend yields’ on commons stocks over the last few years have been extraordinary — rising to 9% by Q3 2006!

With such handsome yields, and price-earnings ratios hovering around fifteen, and with dramatic growth in corporate earnings — surely stocks must be fairly priced!

But, if you’re not in on the buyback bonanza (i.e., if you’re holding stocks ‘for the long run’), then you’ll want to look at corporate results from a PATAB viewpoint. This shows corporate earnings flat, stocks prices over 50 times PATAB earnings, and meagre cash dividend yields of around 3% — definitely a description of an over-priced market.

Think of Buybacks as a Special Preferred Dividend

If buyback money was being paid to a special kind of preferred shares, rather than being used to repurchase common stock, audited financial statements would routinely show common stock corporate earnings in terms of profits after taxes and payments to preferred stockholders.

However, buybacks fall into a blind space in Generally Accepted Accounting Principles, and are treated neither as an expense, nor as profits paid to another class of shares. The reason for this is that buyback benefits are not a contractual right of a certain class of shareholders, but only a benefice, paid out at the discretion of company directors.

Security analysts who follow the Graham and Dodd philosophy, do not take GAAP profits as the Word from the Almighty, but rather as a starting point for logical adjustments necessary in interpreting investments for particular classes of investors.

Stock buybacks are like a ‘preferred dividend’ to executives who hold stock options at no cost and who give value to their own options by using buybacks to manipulate stock prices upwards, exercising these options, with no risk. The ordinary shareholder, in contrast, can only get some of this buyback money by selling stock that was paid for in hard cash and held at risk.

Generally Accepted Accounting Principles (like most rules) were written in the context of expected corporate behavior — many years ago — but times have changed and what was once considered normal behavior is now no longer the case.

The moment a rule is published, smart people find ways it may be bent to their advantage. In this, they are usually successful, forming coalitions of defenders of rules they believe to be beneficial — usually in ways never intended by the rule makers.

The Great Buyback Loophole

A  problem arises in today’s equity markets because corporate stock buybacks total over one trillion dollars every two years, while the rules that deal with the accounting for stock buybacks date back more than a quarter century, when the practice was of minor importance and relatively rare.

Little serious thought has been given to reexamining methods of accounting for stock repurchases in the light of today’s practices.

Now those who place their hands on Generally Accepted Accounting Principles, as if they were a Holy Book, and swear that the method of accounting for stock buybacks is fair and in the best interest of all shareholders, would seem to be on the side of the angels.

But, as Shakespeare noted, “Even the devil can quote scripture.” To many people, the argument that buybacks are accounted for according to GAAP rules is the end of the matter — a signal to turn off their brains and turn on their TV sets. It’s in the Holy Book of GAAP! Why think about it any more?

And indeed, it is difficult to dismiss the rules and think about what really might be a proper way to account for stock buybacks. It’s much, much easier to dismiss the matter as already settled.

But it would be a worthwhile endeavor, because the Great Buyback Loophole is the rule that governs today’s stock markets.

Profits in the Eye of the Beholder

Reports produced by accountants are supposed to provide useful information to various stakeholders in the enterprise.

For example, a report showing EBITDA is of particular interest to bondholders, seeking to evaluate a company’s capacity to cover interest due on bonds they own.

Today’s accounting reports for corporate stockholders routinely show earnings after taxes, adjusted for payments to preferred shareholders that have a prior claim on earnings.

When Wall Street crows about great corporate earnings, they are usually talking about after-tax earnings available to common stockholders.

It all seems so straightforward — the Word According to GAAP — until we try to deal with massive stock buybacks that dominate the US equity markets today.

The Case of Common A and Common B

You will note that accounting reports generally are bound by the legal rights of various stakeholders in an enterprise — not by customary behavior of directors acting under their discretionary powers.

Corporate director have powers to use corporate assets in ways that often are not in the interests of common shareholders, including their right to determine the remuneration of executives and to approve poorly conceived acquisitions and mergers.

Many decisions of directors have a direct bearing on the amount of profits available to common stockholders, but, according to accounting rules, will not be accurately reflected in reported earnings — a case in point being stock buybacks.

Consider the following situation:

Corporation XYZ has two classes of shares: Common A, that account for 5% of the capital, and Common B, that make up the rest. The by-laws state that dividends paid to Common A and Common B are at the discretion of the directors, and need not be the same.

Now, for over twenty years, Corporation XYZ has paid one thousand dollars per share to Common A shares and one dollar per share to Common B shares. In reporting profits to shareholders, however, the directors show the entire profits as belonging to all common shareholders, before dividends. The habits of the board in distributing these dividends according to the peculiar by-laws of Corporation XYZ are not considered relevant.

The price-earnings ratio for Corporation XYZ is calculated by stockbrokers and the financial press (who are friendly with the directors), are on the basis of earnings before dividends, as is customary. When these earnings increase, stock prices rise in line with the price-earnings ratio.

Is this correct and proper?

The directors of Corporation XYZ argue that dividends paid to Common A shares should not be deducted from reported earnings because:

1. Common A has no legal right to any differential dividends from Common B;
2. Dividends paid to Common A have exactly the same accounting treatment as dividends paid to Common B, and both are in accordance with GAAP;
3. Maybe next year, the directors might decide to pay $100 per share to Common B and no dividends to Common A, in which case, to try to report profits “available to Common B” would be shown to make no sense.

Now maybe you have an easy answer for this case, because there are two classes of common shares. Or you may think that no stock exchange would list a company with such strange rules. However, the point being made is that accounting standards do not necessarily present information fairly to all shareholders.

Now, lets advance to a case with only one class of common shares.

The Case of the Foreign Investors

Country ABC has a law that requires foreign investors to get government approval before selling common shares of domestic corporations. This approval takes many months and usually is conditioned on paying a high excise tax and repatriating the proceeds of the sale. Consequently, foreign investors in Country ABC are generally long-term investors, looking mainly to dividends as a return on their investment.

Company XYZ in Country ABC is held one-third by domestic investors and two-thirds by foreign investors, with directors chosen by domestic investors. The directors, inspired by the behavior of directors in the US market, decide each year to declare large stock buybacks and, at the same time, offer all domestic shareholders options to buy an equivalent amount of stock as the amount repurchased at one-half the buyback price.

As a result of this policy, almost the entire profits of the company are used each year for stock buybacks. Domestic shareholders use options to acquire shares to sell into these buybacks, but foreign shareholders, because of government restrictions, can not take advantage of the buyback program.

Foreign shareholders in Company XYZ are required to declare earnings in foreign holdings, even undistributed, with certain tax consequences. The foreign shareholders in Company XYZ complain to their government that this is not fair, because these so-called “profits” are, in fact, used to pay for buybacks. Their government, however, is unsympathetic because, according the GAAP rules, funds used for buybacks are not an expense and should be included in profits.

So here we have a case in which GAAP rules are clearly misrepresenting the earnings of Company XYZ from the point of view of the foreign shareholders.

Most US Common Stock Investors Buy ‘em and Hold ‘em!

There are several things to note about the buyback movement and the behavior of US stockholders:

• Most US investors buy and hold common stocks for long periods, selling only when they retire decades later. Stocks are often held in tax-deferred plans that impose penalties for cashing out too soon. A large portion of investor money is held in equity funds, which means, in essence, that investors are permanently in the stock market.

• A minority of US investors have a stake in corporations, achieved not by holding common stock for which they paid in full, but rather as options, issued without cost, in virtue of their position. This class of common stock investors, in essence, holds shares at no-risk and receives ‘dividends’ of stock buybacks by exercising options for a assured profit.

Most US investor get investment advice from Wall Street brokers and fund management companies that have an interest in portraying common stocks in the best light. Generally Accepted Accounting Principles, by not requiring any special treatment of buybacks, allows Wall Street marketing people to mislead investors, with no fear of criticism from the SEC.

So, now you know. If you benefit from corporate profits as reflected in GAAP (that is, if you are a stockbroker, fund manager, or anyone whose remuneration to tied to accounting profits) then these are indeed the best of times.

However, if you are a modest, long-term investor, trusting implicitly in representations of Wall Street marketing men and women, and if you hold much of your retirement money in common stocks, then you have reason to be alarmed.

How To Create a Bonanza of Real Value for US Common Stockholders

You may have noticed from the above graphs that if Wall Street were to reform, demanding that the money now spent as buybacks be distributed, instead, as ordinary dividends, fairly and equitably to all shareholders, most investors would suddenly be justified in holding common stocks:

• Cash dividend yields would be over 9%, a premium over bond yields comparable to pre-1960 long-term averages.
• Price-earnings ratios would be about fifteen, in line with long-term consensus for a fairly-priced market.
• Corporate earnings would be increasing in line with inflation.
• Total cash return to long-term investors would be consistent with common expectations used in planning for retirement goals.

The chances of this happening are not great.

Common stock investors just don’t know what is going on and Wall Street is not about to tell them. So, in the meantime, unless you are lucky enough to be a beneficiary of the corporate handout, you might consider viewing claims of extraordinary good corporate results with a dose of skepticism.

The Harvard Business Review of February 2007, featured its list of “Breakthough Ideas for 2007″ which sheds light on the regard that US business executives and their mentors now have for ordinary stockholders.

Now, I wouldn’t ordinarily give much attention to an HBR article, but this featured piece claimed to be a “List of Breakthrough Ideas for 2007!” — deemed “provocative and important” by HBR editors — the result of ‘brainstorming’ seminars at the World Economic Forum and discussions among the high and mighty in Davos, Switzerland.

Eureka!

There is nothing like a proclaimed “breakthough idea” to provide us with insights into the minds of those who run the world.

What a Dilemma: Lots of Cash and No Brains!

Breakthrough Idea No. 8 (of the HBR list of 20) was entitled “Borrowing from the PE Playbook” and presented a solution for executives that, as a result of cost cutting and improved productivity, now had an embarrassing “mountain of cash”.

Here is how the case was framed:

“A cash mountain used to be considered a good thing — savings for a rainy day or a war chest for future acquistions. Today, it’s a mixed blessing, and the possibilities for spending the cash wisely are much reduced. For one thing, profitably emptying a war chest isn’t as easy as it once was. Private equity firms are hunting for big corporate deals and using their financial leverage to bid up the prices of acquisition targets — effectively pricing ’strategic buyers’ out of the market.”

“But keeping the cash in the bank isn’t an option. Not only does it generate embarrassingly low returns for investors, but it can make a company more attractive to PE firms. … “

“Some companies resort to share repurchases, but these create value only if the company is undervalued by investors — which is the exception, not the rule.”

“Giving the cash back to shareholders in the form of dividends isn’t a very attractive alternative: It effectively signals that management has run out of promising new growth ideas, which will inevitably effect the share price.“

Huh? Hold it, right there!

Lets get this straight:

• A company is sitting on a “mountain of cash” and doesn’t know what to do with it.
• Stock prices are so high that buying other companies is not easy and equity repurchases are not justified.
• Management doesn’t have any idea what to do with the money, but doesn’t want shareholders to know.

Do Investors Really Despise Dividends?

It used to be — in olden times when common stocks were newly invented — that the whole purpose of buying stocks was to receive dividends when a company was profitable.

It would seem to me, as a humble investor, that a handsome dividend paid as the result of cost savings and productivity gains, should make management look good — at least to my eyes.

After all, dividends are the highest form of “return on investment” — the be-all-and-end-all of John Burr Williams’ formula for valuing equities.

But the Harvard Business Review says that dividends are not only not “attractive”, but furthermore, according to the murky ethics of the Harvard Business School, executives should conceal from shareholders the fact that they’ve run out of ideas of what to do with shareholders’ money, and ought to hold onto to it anyway.

Keep Shareholders’ Cash and Don’t Let Them See You Sweat!

The author of Breakthrough Idea No. 8 goes on to advocate that, rather than pay dividends to stockholders, the wise executive should gamble with the shareholder’s money, trying to buy other firms in an admittedly over-priced, highly competitive market in which management is said to have little experience!

The HBR article claims:

“Like it or not, acquisition really is the only option.”

Really? The only option? How about dividends that were so disparagingly dismissed?

I’m sure shareholders would prefer to receive their money than to have executives piss it away, trying to compete in an overheated acquisition market, about which they know little.

And how about ethics and morals?

Is it right to keep shareholders’ money so they won’t guess that you don’t wake up each morning with a bright new idea of how to make a gazzillion dollars!

Yes, boys and girls, save your money and when you grow up, you too, like Jeff Skilling, can go to Harvard Business School and get your own shiny new “Breakthough Idea”.