Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
December 27, 2003
http://www.dynamicinvestors.net
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The holidays are over and the new-year is almost upon us. I hope you had the opportunity to enjoy the holidays with friends and loved ones. This was the first year in many that I’ve been able to enjoy the holiday season without the tremendous stress of long work hours and evening classes. I had a wonderful time with my new baby daughter and her lovely mother as we counted down the days to Christmas. And as it happens every year, after all the anticipation and the preparation, in the blink of an eye the holiday was gone.
In celebration of the holiday, I decided to take off Wednesday through Friday, and I’m glad I did. It was a short week in the markets this week, with trading ending at 1:00 PM on Wednesday and Friday and closed on Christmas. Volume was extremely light this week, reflecting the holiday season. The Dow ended the week up 46.45 (0.5%) to 10,324.67. The S&P was up 7.22 (0.7%) to 1,095.89. The Nasdaq was up 22.12 (1.1%) to 1,973.14, outperforming the blue chip indices for the first time in many weeks. Treasury yields were relatively unchanged from last week.
Economic news for the week was rather bleak, with the final GDP numbers for the third quarter being the only positive. The economy officially grew at 8.2% in the third quarter, and economists expect around 4% for the fourth quarter and all of 2004. That’s fine with me, so long as job growth comes with it, which doesn’t seem to be the case. Initial jobless claims were 353k for last week, unchanged from the week prior. New home sales were down in November to 1,082k, lower than the market’s expectation of 1,125k. Durable goods orders were down 3.1% in November, reflecting a decrease in non-defense capital goods orders of $4.0 billion dollars. The 3.1% decline is the largest since September 2002, and completely unexpected by the market, which was anticipating a 1% increase. The October durable goods orders were up 4.0%, indicating a 7.1% swing in just one month. Overall, a poor week for economic news.
Retailers were looking for a boost in holiday sales this week, but it doesn’t look good. Target announced that same-store sales for last week were below expectations of 5-7% growth. The hope is that pent up demand from the snowstorms in the Northeast would boost sales in the last few days before Christmas. We won’t know until next week, but if it’s any indication I was able to find parking this week at the malls and shopping centers with no trouble. Wal-Mart did announce a surge in last-minute shopping on Tuesday and Wednesday, but still expects sales to fall in the low end of its forecasts. The final hope for retailers is for people to spend their gift cards in the remaining few days of 2003. Retailers don’t count the sales of gift cards until they are redeemed for merchandise, so if people wait until next year to redeem them, it won’t help this year’s sales. Wal-Mart said card balances were up 20% from last year. (Coincidentally this is a great source of cash flow for retailers, as the cash is collected on the sale of gift cards, with no product leaving the store.
On the employment front, US companies have increased the number of jobs they are shipping overseas, with Morgan Stanley estimating that about 150,000 jobs will be outsourced to India in the next 3 years and as many two-million white collar jobs will move overseas in the next 10 years. If you want to know why the economy is “recovering” but job growth isn’t, look no further.
The US reported its first case of mad cow disease on Tuesday after a sick cow was discovered in Washington State. A second herd of cattle was quarantined Friday in connection with the discovery. Two dozen countries have now banned the import of US beef, including Japan, which imports $1 billion in beef per year from the US. Cattle futures fell by the maximum allowable amount on Wednesday and Friday, with experts saying they could fall another 20 percent before all is said and done. Food company stocks were down this week on the news.
If you like beef, it’ll probably be fairly cheap for a while. Expect chicken and pork to be more expensive, though, as consumers panic and stop buying beef.
The pension under-funding gap, or the amount of money owed to pensioners that companies don’t have, widened by $47 billion this year to $259 billion, despite the rising stock market. This is a problem whose effects won’t be felt for a few more years, until the boomers start retiring en masse. Then you’ll start to see a huge drawdown of these obligations, which will force companies to direct an ever-increasing percentage of profits to retirees. At some point, companies will end up directing more profits to retirees than shareholders, signaling the final triumph of Socialism in the United States.
Finally, in early Saturday trading, the Euro is at $1.242, off from yesterday’s high of $1.247. The euro is hovering dangerously close to the psychologically important $1.25 mark. Spot gold is trading at $411.90 and spot silver is at $5.74. Neither metal felt like taking a breather, as both finished higher on the week.
I’m finishing up the Undervalued Report Company’s “Four for ‘04” report on four defensive investments that will protect you in the new year. It should be available sometime next week, and I’ll be offering a special price for subscribers to the Undervalued Weekly. You don’t want to get caught next year without some security in your portfolio, and this report will show you where to find it.
I’ll be back on Monday with the daily update on the Dynamic Investors site.
Enjoy the weekend, and don’t forget to sign up for the subscription promotion.
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Book Recommendation
Are you prepared for the coming economic crises?
If you read one financial book this year, make it Financial Reckoning Day. I’ve just finished reading it, and I can’t recommend it highly enough. Written by the author of The Daily Reckoning, the book delves into the history of markets, economics, politics, war, and just about everything else to figure out what’s going to happen in the future. I’ve been a huge fan of Bonner and the people at the Daily Reckoning for years, and I believe I’m a better investor (and person) for it.
Bill Bonner’s classic wit and humility really show through in Financial Reckoning Day. It’s a quick read packed with a tremendous amount of historical information and analysis. Yet Bonner never claims to know what will happen, but he paints a very convincing picture of what should happen. And it’s not a pretty picture. The story that unfolds in Financial Reckoning Day is one of foolishness, chicanery, and irresistible market forces that have already begun the work of dismantling the biggest lie in history: the world economy of the late 20th century.
Get a copy of Financial Reckoning Day, and enjoy it. Remember that the world won’t end tomorrow, but it could well be a very different place. Are you prepared to live in it?
For more must-have books, check out the Dynamic Investors Required Reading.
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The Perceived Importance of Dividends
Last week’s article discussed the importance of dividends in overall investment returns. Over the last 100 years, dividends provided 5% of the average annual 7% return on common stock investments. Until the 1980’s, dividend reinvestment added more to the S&P 500’s annual return than capital appreciation. Yet most investors have been convinced to shun dividends in favor of retained earnings, under the belief that earnings are put to use more effectively by management than they would be as dividends to the shareholders. Tax implications also contributed to the declining role of dividends, but with the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax advantage of capital gains has been eliminated.
As noted last week, dividend reinvestment provided the majority of the stock market’s return during the last century. Until the late 1960’s, dividends were a sought after characteristic of common stocks, and companies that paid steadily increasing dividends were more valuable than companies that did not. I believe that changes in the structure of stock ownership have led to a reversal in the perception of dividend paying companies.
In the first half of the 20th century, the most influential stock investors were wealthy individuals with large stakes in a small number of companies. These individuals had a great deal of money tied up in their companies and the profits from these businesses provided the bulk of their income. They needed the cash dividends to live.
Normally, these individuals were principles of the company prior to it going public, as both owners and managers. The business was an extension of the owners, and much of their capital was tied up in the company. This meant that the company’s profits were theirs use as they pleased. These were “self-interested” owners, who considered their personal wealth the highest priority. Normally, they did not pay themselves salaries as managers, but took all their income from the company’s bottom line. When the company would go public, this income requirement didn’t go away, therefore the company had to distribute earnings in the form of dividends.
Believe it or not, there was a time when maximizing shareholder wealth was the only goal of corporate management. Realistically, they had no choice but to work strictly for the benefit of the owners, as management was either made up of owners (or in some cases was the owner), or the ownership of the company was concentrated in the hands of one individual who could dictate to management.
Contrast this situation with today’s corporate ownership. Individual majority shareholders in today’s largest companies rarely hold more than a 10% stake, and often less. Most common stock ownership is concentrated in the hands of institutional investors, like mutual funds, insurance companies, and pension funds. These are different kinds of owners, with different priorities and less attachment to any specific company.
Institutional investors are more often looking for capital appreciation, not dividends, and allocate their investments accordingly. The tax advantages of undistributed capital gains (undistributed means the stock has not been sold) constitutes a part of the rationale. The main reason, though, is that dividends are more of a hindrance for institutions than a benefit, because they increase the fund’s cash for investing, forcing the manager to find more investment ideas. It’s easier for fund managers if companies reinvest earnings rather than distribute them.
Theoretically, institutional investors are in for the long haul, but only in an aggregate sense. An institutional manager wants his fund’s value to increase, with little concern for how. Institutional owners are willing to sell their holdings at any time, and will rarely try to work through serious trouble in their portfolio companies. It’s easier for a fund manager to dump a company that’s not performing well and reinvest elsewhere, than it is to work with the company to solve the problems. This is a very different ownership mentality than was common in the era of large individual shareholders.
Obviously I’m generalizing because there are institutional funds willing to work out problems at their portfolio companies. And there are also funds that actively try to invest in dividend paying companies. But these are more often niche funds, with very specific goals. Most funds are short-term investors, driven by annual performance numbers, not long-term growth. Company directors understand this, and while most boards are made up of long-term majority owners, they are essentially beholden to the institutional funds. The individual shareholder-owner has much less influence on management than was the case 50 years ago.
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A company’s managers are the stewards of profits, but they don’t own those profits. Ownership of earnings belongs to the company’s shareholders, a group that might include some members of management. When there were few majority shareholders with power, management was rarely trusted to handle the owner’s money. But as the number of powerful individual shareholders has declined, the reliance on company management has increased.
Management’s job, through daily activity and strategic investment, is to maximize the wealth of the shareholders. Ask any first year business student what the first responsibility of management is, and that’s what you’ll hear. All the items on an income statement are the responsibility of management, until you get to the bottom line. Owners then decide what to do with the profits, which is why the board of directors, not management, sets dividend policy. The utilization of profit is outside the province of management, until and unless the board decides to retain some portion of earnings.
Managers are shareholder’s agents, acting on their behalf. What’s not well understood today, but was years ago, is the inherent conflict of interest between management and ownership when it comes to the utilization of excess earnings. Shareholder’s view earnings as a return on invested capital, or payment for the use of their money, while management views earnings as a source of free capital to expand the business.
Yet retained earnings are not a free source of capital. They are a reinvestment by the owners and are listed as equity on the balance sheet. No distinction is made between retained earnings and invested capital. As such, there is a cost associated with retaining earnings that isn’t visible on the income statement, but exists nonetheless. It is the required rate of return shareholders demand on their invested capital. This required return is represented by earnings growth. For every dollar of earnings reinvested, future earnings must increase by the required rate of return for investors to be properly compensated. I will explain in a future article how this works, but for now you should understand that when a company retains earnings, the owners expect to see a return on those earnings.
In the era of the large shareholder-owners, it was believed that retained earnings should be sufficient to cover what the company needed for continuing operations and capital expenditures, with the remainder distributed to the shareholders. Even today, Warren Buffett requires managers of his portfolio companies to retain only the amount of earnings necessary for continuing operations, and distribute the rest to him. Buffett understands the conflicting interests of managers and owners, better than anyone I’ve ever studied.
When a company has many small, individual shareholders, the earnings applicable to any one owner are relatively small. A small change in per share earnings doesn’t matter much to them, as it has little effect on their wealth. On the other hand, a majority owner with a lot of shares will be concerned with every minor change in per share profits.
For example, suppose you have a company that earns $100 million in profits, and has 100 million shares outstanding. Shareholders own $1 in profits for every share they hold. If one owner held 50% of the company’s shares, his stake in the profits would be $50 million. It’s reasonable to believe that this owner would be concerned with every penny of EPS, and whether it’s retained or distributed as a dividend, because that penny represents $1 million in profits.
We would expect this owner to value his cash dividends highly, as they will make up a large portion of his income and wealth. On the other hand, to the shareholder who owns say, 1000 shares, a penny per share of the company’s earnings amounts to $10. Hardly enough to be concerned about. We wouldn’t expect this investor to go through the sometimes arduous process required to exert pressure on company management. The small investor will fill out his proxy based on management’s advice (if he fills it out at all), and doesn’t think about it for another year. If he gets tired of the company, he sells his shares and moves on.
The ownership of common stock today is made up more of small shareholders than large shareholders, which has led to an increase in management discretion to a much greater extent than in the past. It’s no coincidence that the perception of dividends began to decline at about the same time the mutual fund industry began taking off in the late 1960’s. The rise of institutional investors has led directly to the decrease in the importance of dividends and the improved perception of management’s ability to handle retained earnings.
With new tax laws in place, and the recent revelations that company management hasn’t always operated with shareholder interests in mind, some changes are likely in order. We could begin to see a reversal in the perception of management, and an increase in the desire for dividends.
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Quotes of the Week
"The only good luck many great men ever had was being born with the ability and determination to overcome bad luck.”
-Channing Pollock
"Every worthwhile accomplishment, big or little, has its stages of drudgery and triumph; a beginning, a struggle, and a victory."
-Ghandi
Have a wonderful New Years, and I look forward to 2004.
Sincerely,
Christopher M. Mallon
P.S. – You’ll notice that this week’s book recommendation is the same as last week’s. That’s because I feel so strongly about the value of this book. It’s truly a great read, and one that you’ll be glad you own.
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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If you’d like to advertise in the Undervalued Weekly, please send e-mail to chrismallon@dynamicinvestors.net. My rates are reasonable, and I’m willing to work deals for ad swaps and joint ventures.
Attention authors!
The Undervalued Weekly is always looking for quality original content. If you’d like to write an article for publication in the Undervalued Weekly, send a copy of your article to undervalued@dynamicinvestors.net. Include a one-paragraph abstract of your article, and a working e-mail address. I will contact you if your article is approved. I reserve the right to correct any grammatical mistakes.
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