I

went home from my busyness and later to dream
that on a street named Wall there were miles of ticker
floating like a river with no end;
stocks nurturing new business,
funding fresh ventures yet ultimately awash
like flotsam – trading endlessly between random hands,
signifying little beyond this or that turn of the cards,
beating the Street for now, yielding to it thereafter.

For the market’s magic consisted primarily of hope –
a smiling phantom this,
such that whoever reached for it touched only meager dividends
and eventually plead with not a small amount of guile
“take these shares off my hands at higher prices,
oh future generation of players.
You are my salvation, my pawnbroker,
my source of ephemeral wealth.” 

Ok, so I’m no Robert Frost. Still, it’s a lot easier to write a poem about a neighbor’s fence or a snowy meadow than the stock market. If Frost had thrust his quill in the direction of Wall Street, perhaps he would have become “onomatopoeia” challenged just like yours truly. But “Ticker Tape Charade” is about as close as I’ll ever come to waxing poetic and so I like it. It’s sort of like my wife Sue’s recent interest in painting. Seeing a New York Times article on a $15 million Picasso sold at Sotheby’s, she exclaimed “I can do that for $29.95!” The Earl Scheib of modern art, I guess. And so she did. Her paintings now adorn the walls of our kitchen and will soon spread like the Mad Cow into our living, family, and bedrooms before it’s all over. They’re not Picassos, but they’re good and she likes them. Same thing for me. It’s not Frost, but it’s good and I like it.

Perhaps more importantly, my poetic “Charade” makes a point – a controversial one I’m sure – and one that most naturally would be made by a curmudgeonly bond manager such as myself. The point, quite simply, is that equities as an asset class are not all they’re cut out to be. While their issuance via IPO and secondary distributions facilitates and indeed fertilizes economic growth, their value in recent decades have depended less on the cash flow an investor received via dividends and more on a succession of gullabaloos who believe that stocks always go up.

They do not. And if (up until May of 2000) they have for a good 20 or 50 or 100 years, then their more recent rise has at least in part been based on hope as opposed to an actual return of cash flow or capital from the companies themselves.

I recognize I am in heretical almost blasphemous territory here, and what could be worse than a blasphemous poet; Allen Ginsberg vs. Robert Frost, I guess, which isn’t much of a contest. But I’m going to offer up some statistics and a few examples which may at least get you to thinking about the subject and that, after all, is what poets are for.

My tale of equity woe owes credit at least in part to a curmudgeon even more curmudgeonly than myself – Jim Grant. At times I’ve criticized his market timing but never his intellect, writing ability, or historical financial foundation. The man knows how to tell a story, even if it’s sometimes flavored with nattering, nostrums of negativism. In his book, The Trouble with Prosperity, Grant relates the history of Robert Lovett, a partner with Brown Brothers, who in 1937 wrote an article in The Saturday Evening Post criticizing the belief that stocks (and many bonds) should be locked up and held for the long-term. Although influenced by the Depression, Lovett wrote that “Perhaps we have seen enough by now to concede that no investment is safe or unchanging enough to ‘put away and forget,’ as one is frequently advised to do in periods of rising prices.” In support of his conclusion, Lovett pointed to the startling rate at which the most prominent companies of the prior 35 years had reorganized themselves, declared bankruptcy, or ceased to pay dividends. Rather than using an index, such as the Dow Jones which assumed away corporate mortality by replacing a fallen company with a new freshly scrubbed face, Lovett tracked the 20 most active stocks of 1901 and the 20 most active bonds and followed them through their ups and downs over the next 35 years – a period by the way, which included much more prosperity than economic calamity. Assuming all dividends and interest were spent when received as opposed to compounded (not a bad real life assumption these days outside of 401K land) Lovett found that the most popular stocks had shown a shrinkage of 39% in terms of market value over those 35 years while the bonds had lost 4%. Lovett writes:

After having his capital at risk for 35 years of enormous industrial progress and national growth, our investor would show an aggregate loss of about 25 percent. And one out of four companies in the bond list as well as the stock list would have gone into bankruptcy.

Grant then follows with his own corporate coup de grace. “The crux of (the argument) was that capital in capitalism is consumed, not conserved or compounded, (and) the fundamental reason for capital attrition is that businesses are mortal.”

Cut to April of 2001. I couldn’t do a 35-year study of the most “popular” stocks in 1965, but I did find out that 1 of the 30 Dow stocks in ’65 did eventually go bankrupt (Johns Manville) while 10 have disappeared via acquisition. Since we haven’t had our depression yet and almost certainly won’t anytime soon, the corporate attrition Lovett warned about over our now modern period was almost undoubtedly less. Still, Lovett’s study (and even my modern update) was a reminder that corporations disappear and that holding a stock for the long-term can be dangerous. Doing a Rip Van Winkle on the likes of Cisco, Intel, Dell, or any other “popular” New Age Stock, then is not a strategy to be followed by the faint of heart or even the sound of mind.

But there’s more here than Lovett pointed out and thank goodness for that. I can’t waste my poem pointing out what’s becoming obvious – that some popular companies go belly up. What I’d like to point out is that many companies and even some industries never wind up paying the investor much in the way of dividends even if they don’t disappear. And if you believe as I do (as well as most theorists and academics) that if a company never pays a dividend, or at least not much of one, that its stock price should approach zero rather than par, then much of what we call the stock market is really just a mirage. I called it a “smiling phantom” in my poem, but it just as easily could go by the name of Blanche Dubois in another figurative setting with the allusion that stock prices depend on the kindness and ultimate takeout by strangers.

These overvalued companies and industries I refer to tend to occupy sectors that are capital dependent – so thirsty for capital, in fact, that they can’t return any of it to their stockholders. That thirst, in turn, is almost always ongoing, and nearly perpetual in nature. Still it’s not enough to criticize a company/industry because it needs money. That, after all, is why we have stocks in the first place. But if, due to constant innovation, these companies need more and more money to remain competitive or even stay alive, then stockholders are usually the last in line when it comes to receiving a dividend or a return on their investment. I call this phenomena “cigarette butt capitalism,” because with these companies, the cigars and fresh packs of smokes are used up by their “shadow” equity holders and indeed the ultimate consumers of the company’s product. Public stockholders are left with the butts.

Let me elaborate via example. The U.S. airline industry is in many ways a mirror image of the Internet. Subsidized by the government early on via its role in delivering airmail, it expanded and innovated much like the Net has done in its few short years. It may seem like things have gone from bad to worse in terms of service, but the 707, the 747 and now today’s modern fleet are really miracles in terms of productivity and technological progress. All of that progress, however, has required money – constant flows from depreciation as well as fresh lending, such that over the years the industry has paid little if any dividends. Are you aware that the airline industry has still not recorded a collective cumulative profit over its entire existence? Did you know that the industry leaders have paid only minimal sporadic dividends during the last 35 years and not at all since the late 1980s? How can you value stocks like that? On the hopes that someday they just might – pay dividends? No, common sense would suggest otherwise. Their planes are in fact mortgaged to the hilt and the only real equity returns accrue to “shadow” equity holders such as GE Capital which assume the equity portion of individual airplane leases. Passengers, as well, benefit enormously via cheaper fares and faster planes, but it’s the stockholders that get the “butts.”

Using the airline industry as a straw man looks like an easy crutch until one recognizes that today’s telecommunications industry may be in much the same pickle.

Forced into massive expenditures for licenses and technology in order to survive, dividends are being reduced and in some cases eliminated. Their common stocks which once steadily appreciated on the basis of fair and consistent regulated returns are now moving downward at a steeper slope than the rest of the pack in an uncertain, more competitive, deregulated economy. They are not alone in their quandary; they are just the most visible. Any company that must innovate via massive capital expenditures as opposed to people or R&D is especially vulnerable. They just can’t afford to give much of their returns back to shareholders and their hockable assets have little value in an economy which is rapidly changing.

Which brings me back to the last stanza of my poetic “mouseterpiece” where I point to “hope” as the flying buttress of value in the marketplace. As long as a new generation of investors can be guiled into thinking that dividends are just around the corner for many of these stocks, then there will be “value” and stocks can rise. There may be few reasons to think that they can’t, despite the valiant attempts of this bond prejudiced Outlook – with perhaps one large exception. The “future generation of players” which provides payment to the retiring generation, can do so most easily when the outgoing and incoming generations are roughly proportionate in size. But if a much larger outgoing generation (Boomers) at some point over the next 5-10 years demand payment in full for their shares, then the much smaller future generation of 30-40 year olds may not have enough collective money to pay for it, no matter how successful the “sting.” The older the investor group then, (and U.S. investors will age rapidly as the chart above points out) the harder it becomes to sustain “value.”

At some future point, “hope” will by necessity trade at a discount, P/Es will likely return to historical or less than historical averages, and higher dividend yields may once again represent perhaps the primary source of value for many stocks. Until then, stock investors should march carefully in this ticker tape charade.

William H. Gross

Managing Director