The Good Old Days of White Male Corporate Bureaucracies

Posted on October 4, 2012 by tomdoerflinger

Bottom Line:   Liberals love the 1950s and 1960s when income inequality was far lower than it is today.  But the economy of that era was dominated by large, complacent, bureaucratic corporations, employing few women, immigrants or blacks. Dynamic entrepreneurial activity was limited, in part because taxes were so high.  It worked well for a while but could not handle the foreign competition that emerged in the 1970s.  So the notion that raising taxes on affluent job creators will take us back to the good old days of the 1950s is a fantasy, like Red River Sam (read on).

Full Story

On August 9 we introduced the Marx Brothers (Paul, Joe and Rob).  All three of these illustrious liberal economists bemoan the rise in inequality since 1980. To them the “good old days” were the 1950s and 1960s when America was a prosperous middle class society — when a factory worker could afford a new car and a suburban house; the incomes of all social classes were rising nicely; and the rich were kept in their place with punitive income taxes.  The Marx Brothers would like to take us back to that simpler, more virtuous time, variously lauded as the “great compression,” “great prosperity,” and “good boom.”

But if we go beyond superficial inspection of income inequality data and take a close look at the corporate economy of the fifties and sixes, it becomes clear why it failed in the 1970s and had to be reformed in the 1980s.  The old order was not sustainable and cannot be regained today by raising taxes.

Compressed

In the 1930s and 1940s American society was compressed by potent economic and political forces.  With Wall Street blamed for the Great Depression, taxes on the rich were raised sharply in the 1940s to pay for World War II and kept high in the 1950s to curb capitalist excess.  Wages were raised dramatically in the 1940s not only by acute labor shortages but also by directives of the FDR Administration to companies with government contracts.  The Wagner Act (1935) and other legislation consolidated the power of labor unions. But Big Business fared well nonetheless, thriving on fat cost-plus contracts to manufacture the sinews of war.  The Fortune 100 entered the 1950s with a vastly larger asset base than two decades earlier.  With Japan and Europe shattered by war, foreign competition was negligible and companies expanded overseas, mainly in Europe.

Capitalism without Capitalists . . .

To Americans in the 1950s, “millionaires” were mainly historical curiosities they read about in books. Once upon a time America was an empty continent filling up with immigrants; shrewd capitalists used guile and graft to grab big chunks of the fast-growing economy.  Sociologist C. Wright Mills highlighted “The opportunities to appropriate great fortunes out of the industrialization of America,” via “legal illegalities and the plainer illegalities.”  Mills reminded readers “we must also bear in mind that the private industrial development of the United States has been much underwritten by outright gifts out of the people’s domain.”

This flawed historical narrative shaped Americans’ understanding of what was possible and proper in a private economy.  In the first place, the pecuniary triumphs of the “robber barons” were deemed to be illegal and immoral; their brutal enterprise was not welcome in a more civilized post-war America.  But, secondly, it was not repeatable anyhow because the American economy had already been built – the railroads constructed, the copper mines claimed, the timberland acquired, the oil wells dug.  Building the Great Fortunes was a one-off event.  Thirdly, in this telling of economic history there was no room for past or future business geniuses who build the proverbial “better mouse trap”; one did not get rich simply by creating a great product.  It was all about manipulating money on Wall Street and votes on Capitol Hill.  Thus Matthew Josephson’s influential history The Robber Barons (1934) is dominated by financiers and railroad building wheeler-dealers like JP Morgan, Jay Gould, Daniel Drew and Cornelius Vanderbilt – not makers of great consumer products such as refrigerated meat (Swift), canned pickles (Heinz), soap (Gamble), and cheap autos (Ford).

By the 1950s the business structure was believed to be pretty much “set,” with a handful of corporations controlling each industry.  The corporate order was now a melding of rich owners of major firms (DuPont, Rockefeller, Ford, etc.), and the corporate executives who actually ran them.  The owners were mostly “old money.”  C. Wright Mills inspected the 95 richest families over time and found that the percentage that had originated in the upper class (and thus were not upwardly mobile) had climbed steadily; it was only 33% in 1900, 56% in 1925 and 68% in 1958.  Rich families kept their heads down and their spending discrete; for the truly rich this was an era of “inconspicuous consumption.”

. . . or Competition

Crucially, in the 1950s these top companies had little to worry about, competitively speaking.  Each industry was dominated by a handful of companies.  Harvard economist John Kenneth Galbraith claimed that they made their own weather, and maybe their own climate.  There was a “massive reduction of risk” in the corporate economy because:

  • Companies protected themselves from changing consumer taste via advertising and a broad, diversified line of products.
  • Research and development protected companies from new technology.
  • The companies’ large size gave them pricing power and therefore a measure of control over earnings.  Price competition had been replaced by “administered pricing.”
  • This control over financial results gave companies easy access to the capital markets, which smaller firms lacked.  So competition from below was limited.
  • Firms’ large size and bureaucratic structure reduced the risk associated with changes in leadership.

Entrepreneurial Void

While Big Businesses became ever bigger and more secure, small businesses were expected to stay small in the 1950s, in part because taxes were so high.  Sociologist William Whyte wrote, “The great majority of small business firms cannot be placed on any continuum with the corporation.  For one thing, they are rarely engaged in primary industry; for the most part they are the laundries, the insurance agencies, the restaurants, the drugstores, the bottling plants, the lumber yards, the automobile dealers.  They . . .do not create new money within their area.”   C. Wright Mills agreed: “the misleading term ‘entrepreneur’ does not have the same meaning when applied to small businessmen as it does when applied to those men who have come to possess the great American fortunes.”  He noted that by the mid 20th century “it has become increasingly difficult to earn and to keep enough money so as to accumulate your way to the top.”  A key reason for this lack of upward mobility was, of course, confiscatory tax rates for Americans who made too much money.

Red River Sam and the Millionaire

A 1961 episode of the TV show “Leave It to Beaver,” illustrates Americans’ belief that fortune-making was a thing of the past.  Beaver Cleaver, a wholesome middle-class suburban fifth grader, finds his father (Ward) fretting in the den over the monthly bills he had to pay.  Ward grimaces when Beaver asks him if he will ever have a million dollars; later Ward complains to his wife June, “He wanted to know when I would become a millionaire.”

Upstairs in the bedroom they share, big brother Wally explains to Beaver that these days you become a millionaire by finding oil, which is why all the millionaires are in Texas.  But the next day Beaver takes the money he had planned to spend on a novel about the cowboy Red River Sam and buys his father a book on how to get rich.  When presented with the book, a flustered Ward assures Beaver he will put it in “an honored place in my library” but it ends up amidst the cookie crumbs in a drawer in the kitchen.  After discovering the discarded book a sulking Beaver hides in a tree, but eventually he and his father make up; Ward buys his son Red River Sam in Montana.  In 1960s suburbia millionaires, like cowboys, were fantasy figures.

The Cult of the Business Bureaucracy

In the 1950s the modern corporation was considered to be a novel, almost post-capitalist institution. Stockholders were pushed to the background.  Explained a sociology textbook, “All are employees, not owners. Their places in the system depend upon the rules of bureaucratic entry and promotion; business is coming more and more to assume the shape of the government civil service.”  C. Wright Mills agreed that “During the last three decades…the distinction between the political and the economic man has been diminishing.” The modern manager “has the political job of keeping all his constituents reasonably happy.”  In this new institution, the key to success was not generating profits but getting promoted, which, Mills claimed, had little to do with merit and everything to do with pleasing your boss: “Only if the criteria of the top positions were meritorious, and only if they were self-applied, as in a purely entrepreneurial manner, could we smuggle merit into the statistics.”

Whether meritorious or not, the modern corporate executive intrigued Americans.  Fortune ran a long article detailing their manners and mores — their hobbies, houses, daily routine, and even their family life.  Gender roles were appallingly well-defined.  Don Mitchell, the president of Sylvania Electric Products, explained that his social life was limited, and while he found stimulation from business his wife “probably finds the life boring. Her job is to bring up the children and keep my health reasonably good.”  In one of the most influential novels of the 1950s, Sloan Wilson described the early career of The Man in the Grey Flannel Suit – a Connecticut commuter, Tom Rath, who goes to work for the CEO of a giant media company headquartered in Rockefeller Center. Tellingly, Tom’s first assignment has nothing to do with profits.  He spends weeks perfecting a speech promoting research on mental health, which his boss delivers to a convention of doctors.

Collectivist Capitalism

In The Organization Man William Whyte claimed that corporations promoted a collectivist “social ethic” in lieu of the individualistic protestant ethic of an earlier era.  Executives have “taken a vow of organizational life” and are preoccupied with “group work” be it the work of the overall company or the “people at the conference table.”  The traditional virtues of self reliance, thrift and competitive struggle were less necessary when the economy was booming.  On college campuses, “the descent, every spring, of the corporate recruiters has now become a built-in feature of campus life” and the smarter grads had no problem getting several offers. Unlike college grads of the 1920s, who speculated in the stock market, they were not too worried about money; one recruiter claimed that in 300 interviews not one candidate brought up the issue of salary.

To make sure employees “fit in” to the corporate culture, personality tests were used; Sears Roebuck, for example, tried to screen out people who scored highly on aesthetics because “this is not a factor which makes for executive success.”  The transition from college to company was undemanding; instead of venturing out into a “hostile world” new recruits were coddled in lengthy training programs (GE’s lasted two years).  They would become bureaucrats in organizations that, increasingly, viewed themselves as national institutions rather than businesses – a status memorialized in the lavish corporate pavilions at the 1964 World’s Fair (see next post).

The collectivism of the corporation, Whyte believed, was reinforced by the new suburban housing developments springing up around the country.  Here residents lived in nearly identical houses, went to the same parties, shared appliances such as lawn mowers, and watched the same TV shows. As incomes grew, consumer luxuries metamorphosed into necessities.  Robert Reich recalls how his father was the first person in the neighborhood to buy a TV.  “I remember neighbors crowding around it to watch Milton Berle in Texaco Star Theater.  Within the decade, almost every family had its own TV.”

White Males Dominance

In the supposedly equalitarian wonderland of the 1950s so lauded by the Marx Brothers, virtually all the responsible corporate jobs were held by white males.  The U.S. was still a deeply racist country; virtually no blacks were to be found in executive suites. Ditto white women; the labor force participation rate of married white women in 1950 was only 21%, versus 49% by 1980.  Not until the late 1950s did women start to get full MBA degrees from Harvard Business School.  A little-noticed reason for the rise in income inequality since the 1950s is the emergence of the two-career couples; many more women have high-paying jobs and are married to affluent males.

As for immigration, the door was shut to most foreigners in 1924, so very few bright young immigrants in their 20s and 30s were striving for success in the post-war corporate bureaucracy.  In 1970 only 5% of Americans were foreign-born, versus 15% today.  Here, too, social change has boosted income inequality.  Although some immigrant are highly skilled, most have limited skills and low incomes; their absence from the U.S. labor force made the 1950s economy appear more equal to uncritical observers, such as the Marx Brothers, than today’s economy.

It Worked for a While . . .

An economy dominated by big, complacent, bureaucratic companies that were largely deprived of the skills of blacks, women, and immigrants might seem to be doomed to mediocrity or worse.  But productivity growth was strong in the 1950s and 1960s. Why?  A  few ideas:  After 20 years of depression and war, Americans were eager to get down to work, and there was strong pent-up demand for consumer goods such as autos and housing.  And U.S. firms could commercialize technological innovations that had been developed in the 1930s and 1940s.  (A good example is the computer, developed during the War at the University of Pennsylvania and elsewhere aim cannons accurately).

. . . But Not Forever

U.S. firms became vulnerable to foreign competition because there was little pressure to keep quality high and costs low.  Companies could raise prices to meet the demands of unionized labor.  Ford executive Lee Iacocca admitted, “In those days we could afford to be generous.  Because we had a lock on the market, we could continually spend more money on labor and simply pass the additional cost along to the consumer in the form of price increases.”  In the 1970s productivity slowed sharply, price increases led to cost-push inflation, and U.S. firms lost market  share to foreign firms.  Entrepreneurial activity—weak enough in the fifties and sixties—was stifled by rising capital gains tax rates (see our Sept. 27 post).

But the tax cuts, deregulation, and strict monetary policy of the 1980s Reagan revolution, so reviled by the Marx Brothers, eventually restored the vitality of the American economy. Wall Street funded hard-charging start-ups such as Apple, Genentech, Dell, and Microsoft which created millions of jobs. Private equity players financed by notorious junk bond king Michael Milken carved up dysfunctional conglomerates and pressured companies to cut costs and maximize shareholder value.  So corporate America became more efficient and competitive; productivity growth accelerated in the 1980s and 1990s.  (See our June 16 post.) The last thing the U.S. needs is a return to the high-tax bureaucratic capitalism of the 1950s.  The world has change, and there is no going back.

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Joe Nocera Forgets History

Posted on September 27, 2012 by tomdoerflinger

Joe Nocera of the New York Times laments that the notorious billionaires on the Forbes 400 list mainly pay capital gains tax rates. He quotes Mitt Romney saying a low capital gains rate is “the right way to encourage economic growth, to get people to invest, to start businesses, to put people to work.”  Nocera claims, “there is no evidence that it is true,” and there is “no correlation” between the capital gains tax rate and the state of the economy.

Take a closer look, Joe.  Plagued by slow growth, surging regulation and rising taxes, the Obama economy resembles the Carter Economy of the 1970s.  In the 1950s and most of the 1960s the maximum capital gains rate was 25%.  But as politics took a radical turn the top rate moved higher and higher, to 26.9% in 1968, 34.25% in 1971, 36.5% 1972- 75, and 39.875% 1976-78.  Rising taxes on risky investment was part and parcel of the economic malaise of the 1970s that pushed the “misery index” (inflation plus unemployment) ever higher—from 6.77 under President Johnson to 16.26 under Carter.  Venture capital pretty much dried up in the later 1970s, real stock prices plummeted, and the poverty rate rose.  When Amdahl Computer, which was founded by a top IBM scientist, needed more capital in the 1970s it had to go to Japan.

One of the first big pro-capitalist reforms to correct the Carter Malaise came in 1978 with the Steiger Amendment that lowered the top capital gains tax rate from 39.875% to 28%.  The stock market responded. In 1980 there was a new issues boom, focused on high tech and energy companies.  One of the new issues was a company called Apple Computer; another was Genentech.  In 1980 they were extremely risky investments, appropriately taxed at a lower rate.  When inflation plummeted in 1982 and stock prices surged, there was another new issues boom in 1982-83.  The personal computer and biotech industries were two sectors that created many jobs while energy and heavy industry, hit hard by disinflation, was hemorrhaging hundreds of thousands of jobs.

Today, as in the 1970s, a rising capital gains tax rate would throw yet another Washington Wet Blanket on the private economy, keeping unemployment high while raising little or no incremental revenue (because as tax rates climb investors take fewer gains).  Say it ain’t so, Joe.

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Dividends: Beware Feeble and Fading Aristocrats

Posted on September 14, 2012 by tomdoerflinger

I like dividend paying stocks and have been writing about their virtues since early 2009, well before they became the rage on Wall Street.  I like them for a few reasons.   Most large, mature U.S. companies can pay a decent dividend without hurting their EPS growth, so it enhances investors’ total return.  Unlike share buy-backs, dividends continue to be paid during recessions, generating cash that can be invested in stocks when they are cheap.  Dividends impose more financial discipline on corporate managements than share buy-backs because they have to be paid every quarter and are far more transparent.  Unlike dividends, buy-backs  can be announced but not executed, or executed but offset by issuance for acquisitions or employee stock options, so the share count does not actually decline.  Finally, dividends are convenient; investors don’t need to decide when to sell shares.

But these virtues must be kept in perspective.  Using dividends as the primary stock-picking criterion is a good way to lose money.  The value of a company is determined not by its payout policy but by its fundamentals –  its ability to earn returns above its cost of capital and to generate free cash flow.  Dividends are not necessarily a good indicator of these fundamentals.  Many companies with poor fundamentals can afford to pay high dividends, at least for a while.  Indeed, some firms, including quite a few utilities, are effectively financing their dividends not with internally generated funds, but rather by issuing new shares.  High yields can be particularly deceptive, because they are lagging indicators.  When the fundamentals of a company are deteriorating (think GE in 2008), corporate boards of directors are the last to know; as the stock price slides the dividend yield will rise, enticing nvestors  until the board wakes up and belatedly slashes the dividend (think GE in 2009).

One good example of the risk that comes from putting the dividend cart before the fundamentals horse is Standard & Poor’s “dividend aristocrats” – 51 stocks in the S&P 500 that have raised their dividend every year for at least the last 25 years.  Specifically:

  • Quite a few of the aristocrats are feeble and fading old-line companies.  Of the 51 stocks, 10 are expected to grow their dividends by 4% or less in 2012, and 17 by 6% or less.  Average 2012 dividend growth for all 51 is 8%, well below the 14% forecast dividend growth of the entire S&P 500.  (S&P dividends rose 14% in the first half of 2012.)
  • As one would expect, the list is skewed toward such sectors as industrials, materials, and consumer staples.  There are no biotech companies and only one technology stock – slow-growing ADP.  The list completely overlooks one of the most exciting trends for dividend-oriented investors—large, powerful, cash-rich  tech companies such as Intel, Apple, Microsoft, Qualcomm, and  Cisco are raising their dividends rapidly.  The aristocrats also exclude younger consumer companies such as Nike, Starbucks, Footlocker, Darden, etc.
  • The mean payout ratio of the aristocrats is fairly high at 46% (versus 28% for the S&P 500), and 13 companies have payout ratios of over 60%.  This suggests that future dividend growth will be slow.
  • The list is also badly skewed by the financial crisis, when virtually all major banks were required by regulators to cut  (or at least not raise) their dividends in order to strengthen balance sheets.   Many of these banks are well-managed, attractive plays on a U.S. housing recovery, and they have the added virtue of little or no exposure to Europe.

Bottom line:  It is a mistake to simply invest in the Dividend Aristocrats Index (or an approximation thereof), because you will own too many weak, slow-growing companies while systematically avoiding attractive areas such as technology and banks.  It makes more sense to use the Aristocrats as a “shopping list,” favoring those stocks that have fairly strong dividend and earnings growth, positive stock price momentum, dividend payout ratios below 60%, and rising consensus EPS estimates.  To these should be added quite a few non-Aristocrats with strong fundamentals, decent yields of 2-4%, and rising dividends.

The Aristocrats’ defenders may protest that they have tended to beat the market over time.  Perhaps so, but keep in mind that recently the market has favored stocks that pay dividends and are in defensive sectors, such as consumer staples.  Stocks fitting that description (including many aristocrats) have become fairly expensive and may not continue to outperform, particularly if their fundamentals are lackluster.  The boilerplate caveat, “Past performance is not an indicator of future results” is definitely relevant here.

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krU-Turn: The Depression Ended in August

Posted on September 9, 2012 by tomdoerflinger

A Chronic Depression . . .

While you and I were on vacation, Professor Paul Krugman was making the rounds of TV studios, flogging his book End This Depression Now.  He defines the current “depression” as a “chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards collapse.”  This condition results in high unemployment that is blighting the lives of millions of Americans.

. . . Requires Aggressive Policies . . .

But this pain is avoidable, Krugman tells us, if Washington would just pursue tried-and-true Keynesian economic policies.  He wants Washington to help under-water homeowners refinance their mortgage.  To avoid more layoffs of teachers and policemen he recommends new “stimulus” spending of $300 billion annually.  More radically, Krugman wants the Fed to double its inflation target from 2% to 4% in order to shrink the value of outstanding debt.

Without a doubt, these policies would be risky. With the U.S. already running a huge budget deficit, America’s creditors could be spooked by even more stimulus spending, a shift toward higher inflation, and a resulting weaker dollar. Treasury refundings could become white-knuckle affairs, like those in Spain and Italy. And higher inflation would depress real wages while shrinking the savings of Americans invested in money market funds and bank CDs.

. . . Never Mind

But as summer turns to autumn, the days get shorter, football season begins, and Professor Krugman’s book royalties roll in, we are relieved to learn that it was all a big misunderstanding.  America does not, after all, need to take risky new measures to end a debilitating depression.  Far from being a “chronic” condition, the depression Krugman warned about in June and July is ending in September!  Or so we are informed in his September 7 New York Times column, which states “the forces that have been holding the economy back seem likely to fade away in the years ahead.” Specifically:

  • The housing market is recovering.
  • Consumers have deleveraged; “the ratio of debt to GDP is way down from its peak, setting the stage for stronger consumer demand looking forward.”
  • Business investment “has been recovering rapidly since late 2009, and there’s every reason to expect it to keep rising as businesses see rising demand for their products.”

Consequently “the odds are that barring major mistakes, the next four years will be much better than the last four years.”  So we can all ignore the supposedly rigorous economic analysis in the book Krugman was hawking two months ago and reelect Barack Obama President.  Who knew that Mr. Krugman was a VCP (Very Commercial Person) and a VFE (Very Flexible Economist)?

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Muted Expectations Could Set the Stage for a Positive Stock Market Surprise

Posted on September 4, 2012 by tomdoerflinger

Wall Street Strategists’ Forecasts . . .

As we head into an action-packed final third of 2012, Wall Street strategists are taking a cautious view of the U.S. stock market.   But if the election in November brings more pro-business policies, stocks may beat low expectations over the next year as PE ratios expand.  Based on data just published in Barrons, twelve top equity strategists, hailing from both the “sell side” and “buy side” of Wall Street, are forecasting:

  • 2012 S&P 500 EPS of $102.25. This is reasonable but probably still too high.  The bottom-up estimate (reflecting analysts’ estimates for the 500 companies) is $103 but is likely to fall further over the next six months given weak growth in virtually every corner of the globe except Washington DC.
  • 2013 S&P 500 EPS of $108, implying 5.6% earnings growth next year.  This is also a bit too high, given very elevated profit margins that won’t climb further in a weak economy.  However a number like $106 is reasonable; it only requires stable margins, low single-digit revenue growth, and a 1-2% decline in share count driven by share buy-backs.
  • The strategists’ year-end 2012 price target is 1425, implying a trailing PE of 13.8x and a forward PE of 13.2x (all based on median forecast of the 12 strategists).

. . . Are Consistent with a 7.5% Total Return Over the Next Five Quarters

Let’s suppose the strategists’ forecasts for EPS are a little high and their forecast for PE is reasonably accurate.  What does this imply for investors’ total return between now and year-end 2013?

  • If we assume that 2013 EPS is $106 (only slightly below current forecasts) and that the year-end 2013 trailing PE is 13.8x (i.e., same as 2012), then the S&P 500 would be at 1463 by year-end 2013.
  • In addition, based on my fairly bullish view of dividends, the index should pay a Q4 2012 dividend of $7.47 and a 2013 dividend of $34.50, or $41.97 over five quarters.

Using a current price for the S&P 500 of 1400, price appreciation by year-end 2013 would be $63 (1463 minus 1400) and total dividends would be $41.97, for a total return of 7.5% — (63 + 41.97) / 1400 = 7.5%.  That is quite attractive when interest rates are so absurdly low.   The primary down-side risk, which is certainly non-trivial, is that Washington takes the U.S. economy over the fabled “fiscal cliff.”

The Upside Risk from Pro-growth Policies

But we should not lose sight of upside risks as well.   Wall Street’s strategists are using PE assumptions that are very conservative by historical standards, particularly considering that we are in a low-inflation, low-interest rate environment.   From 2003 through 2007 the average trailing PE of the S&P 500 was 17.3, or 3.5 points above strategists’ assumptions discussed above.  The average forward PE, 2003-2006, was 15.2x, or a full 2 points above current assumptions.

If investors become even modestly more positive about the future of the U.S. economy, PE ratios could expand from current low levels.  And modest expansion could have a big impact on stock prices; you don’t need a full reversion to historical norms to get significant upside.  For example, if at year-end 2013 the trailing PE was 15x rather than 13.8x (still well below the 2003-2007 average of 17.3x), the S&P 500 would be trading at 1590 and total return over the next five quarters would be 16.6% rather than 7.5%.   (The calculation is: 1590 – 1400 = $190 in price appreciation, plus $41.97 in dividends equals a total return of $231.97; 231.97 / 1400 = 16.6%.)

Why Romney Ryan Could Boost the PE

As discussed in my July 9 post “The Other Keynesian Paradigm,” the poor recent performance of the U.S. economy can be traced to the “great suppression” of capitalistic “animal spirits” by the Obama Admnistration.  Even if one is properly skeptical of the more grandiose elements of the Romney-Ryan agenda, it is not hard to envision them carrying out enough pro-business policies to lift the PE ratio modestly. These likely would include:

  • Boost morale  by ending the “spread-the-wealth” “you didn’t build that” rhetoric, in favor of a pro-growth “we can do this” message.
  • Cut back on regulation, beginning with the EPA’s war on fossil fuels and at least curbing the impact of Obamacare and Dodd Frank.  Because the Supreme Court has deemed Obamacare’s “individual mandate” a tax, it can be repealed in the Senate with just 51 votes.
  • Corporate tax reform that cuts the top rate to 25%, broadens the tax base, and shifts to a “territorial” system of taxing the foreign profits of U.S. multinationals.  This may sound ambitious but it is really a “no brainer,” recommended by Obama’s own Simpson Bowels Commission and similar to how nearly every other developed nation taxes corporations.
  • Tax reform would likely include an incentive for companies to repatriate cash “stranded” overseas.  Because the cash would be taxed at a low rate, this initative would not cost Uncle Sam much, but it would be very positive for shareholders because the repatriated cash would be spent on dividends, buy-backs, M&A, and capital investment.
  • Another “no-brainer” reform, which Romney unwisely does not discuss much even though he touts it on his campaign website, is H1-B Visa reform allowing many more of the “best and brightest” immigrants to work in the U.S. after getting engineering and scientific degrees from American universities.  This would improve Republicans’ standing with immigrants and could not easily be opposed by Democrats in Congress.  (Obama has opposed it, over the objection of his Silicon Valley supporters, on the grounds that it should be part of a comprehensive immigration reform package.)

These reforms would raise “animal spirits” in the private sector and lift PE ratios on Wall Street.  Although gloom is currently fashionable, an optimistic turn is not hard to envision because there are many positive developments in the U.S. economy that are not receiving the attention they deserve.  The housing sector has bottomed and is starting to grow again.  Households have delevered, with liabilities down 5.7% since 2007 while financial assets are up very slightly.  State and local governments are also balancing budgets successfully, with only a few defaults.  The North American energy boom could make the continent nearly energy independent in a few years; cheap and secure energy would lure manufacturing back to the U.S.   And, in contrast to the dark days of the early 1980s, U.S. corporations are highly competitive globally in a great many industry sectors, including:

  • Electronic technology, ranging from chips to servers to smart phones to software
  • Consumer brands, from Coca-Cola to Harley Davidson
  • Finance; yes, Wall Street is in disarray, but EU banks are in much worse shape.
  • Energy, including sophisticated services
  • Pharmaceuticals, biotech, and medical equipment
  • Agriculture (including seeds, chemicals, and equipment)
  • Aerospace, both civilian and military
  • Capital goods ranging from electrical equipment to trucks to gas turbines
  • Retailing, from Wal-Mart to Tiffany to Amazon
  • Entertainment, from Disney to Wynn Resorts

The Table below shows the 2006-2011 growth rate for selected categories of U.S. exports.  It’s an impressive performance, considering it spans the worst economic downturn since the 1930s.

Bottom Line

Although the Fiscal Cliff does pose a risk, the “base case” for equities of 7.5% total return over five quarters is attractive, and stocks could deliver a significantly higher return if  Washington’s economic policies improve.

 

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Are Democrats Anti-Black?

Posted on August 28, 2012 by tomdoerflinger

It is a dumb question, but not nearly as dumb as the question, widely pondered (and answered in the affirmative) by the mainstream media, of whether Republicans are anti-women.  There is plenty of hard evidence that Obamanomics has not only been disastrous for Blacks and Hispanics; it has been far worse for minorities than for White Americans.  If Obama were the CEO of a private company, he could be sued for the “disparate impact” of his employment policies on Blacks and Whites.  Just compare labor statistics at comparable points in the administrations of George W. Bush and Barack Obama (i.e., July 2004 and July 2012):

  • Unemployment has increased more for Blacks than Whites.  Black unemployment has climbed 310 basis points (14.1% vs. 11.0%) while for Whites it has climbed only 270 bps (7.4% vs. 4.7%).
  • The labor force participation rate has declined more for Blacks than Whites.  The Black rate has dropped 290 bps (64.3% to 61.4%) while the White rate has dropped 250 bps (66.5% to 64.0%).
  • The Employment Population Ratio has declined more for Black men than White men.  The Black rate has declined 560 bps (63.3% to 57.7%) while the White Rate has declined just 480 bps (73.2% to 68.4%).

Obamanomics has been similarly disastrous for Hispanics and for workers with less education and lower incomes.  So the evidence that Democrats are anti-Black is compelling—far more compelling than the suggestion that Republicans are anti-Women.  Furthermore, there is no doubt that Romney and Ryan’s pro-growth, pro-employment policies would be positive for blacks and Hispanics, and very likely more positive for them than for Whites.

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Green Poverty

Posted on August 23, 2012 by tomdoerflinger

The absurd spectacle of the U.S. burning 40% of its corn crop as ethanol during a drought that has sent corn prices skyrocketing exemplifies a broader problem.  While professing grave concern about “wage stagnation” and the financial plight of the forlorn 99%, many in Washington push environmental policies that depress real wages and living standards while increasing inequality.  The cost of commodities is raised by many “green” policies including:

  • ethanol mandates
  • the EPA’s war on coal as a source of electrical power
  • opposition to fracking to produce oil and gas
  • opposition to the Keystone XL Pipeline and other pipelines
  • opposition to nuclear power
  • restrictions on oil drilling offshore, in Alaska, and on Federal land
  • “renewable portfolio standards” mandating electric utilities use increasing amounts of costly  “alternative fuels”
  • California’s anti-farming water policies

It might seem that calculating the hit to living standards from rising commodity costs would be difficult, but that is not the case.  To measure the trend in “real” or inflation-adjusted incomes, the Bureau of Labor Statistics deflates nominal wages by the Consumer Price Index; all else equal, the faster the CPI rises, the slower real wages grow.  But an alternative price index is available—the “Core” CPI, which excludes food and energy.  By comparing trends in the Total CPI and Core CPI, we can see how much rising (or falling) commodity prices are impacting living standards.  It turns out that this was a key driver of the “wage stagnation” during George W. Bush’s administration.  Whereas declining commodity costs boosted real wages during the 1980s and 1990s, they reduced real wages after 2002.  See Table 1.

So in the 1980s and 1990s the Total CPI lagged the Core CPI by 0.3% per year, or nearly 11% over a nineteen-year period, because of weak commodity prices; this boosted real wages by 11% over the period.  But over the next decade this pattern reversed.  With the price of food and energy rising much more rapidly than other products, the Total CPI rose faster than the Core by 0.6% annually, or 7.5% over a decade.  In other words, real wages would have been a huge 7.5% higher if commodity prices had only climbed as fast as other products in the CPI basket.

Now, it’s true that not all the recent strength of commodity prices can be blamed on green policies. Rapidly rising emerging market demand for commodities certainly was an important driver.  However, commodity inflation has been systematically exacerbated by green policies that constrain production of inexpensive food, coal, natural gas, oil, and electricity.  (Food is an energy-intensive commodity, due to fertilizers, transportation, etc.)  Judging from various progressive websites, liberals almost completely ignore this driver of poverty.  And more conservative observers fail to emphasize it enough.  All around, there is a dearth of “lateral thinking” – spotting the unintended side effects of environmental laws.  As an aside, these laws have unintended environmental side effects as well; paving thousands of acres of pristine desert with solar panels is an obvious example.

Green Inequality

Because food and energy claim a larger share of the budgets of low income families, Green Poverty exacerbates income inequality.  Households with incomes of $30,000-$40,000 spend 19% of income on food and energy while affluent households spend just 9%.

The U.S. is entering a new era of energy abundance, but thus far green policies have limited the payoff to consumers and workers.  If a Romney Administration pursued a pro-growth, pro-consumer, pro-worker energy policy emphasizing “all of the above” production along with increased energy efficiency, the resulting growth in employment and restraint of commodity prices would raise living standards and reduce poverty fairly quickly.  This would benefit low-income consumers far, far more than efforts to redistribute income via the tax code, which mainly pad the already fat wallets of bureaucrats and influence peddlers in Washington DC—already the richest area of the U.S.

cpi headline, cpi core, green poverty

 

 

 

 

 

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“Not Doing Too Much” – Smart Cash Deployment Enhances Total Return

Posted on August 21, 2012 by tomdoerflinger

Twelve years ago stock market investing was all about earnings growth while dividends were BORING.  Now the reverse is true, with investors “reaching for yield” while growth is, arguably, under-priced.  Investors need a framework for evaluating the trade-off between growth and yield.

Start with successful mid-size company XYZ Corp., which is growing profitably.  Should it pay a dividend?  The answer, especially in the current slow-growth environment with a dearth of good investment opportunities, is “No.”  So long as the return on its new, or “incremental,” investment is greater than its cost of capital, it should make those investments rather than pay out capital.

Reaching for Rapid Growth: Risky

Fast forward five years.  Now XYZ Corp. is 50% bigger and its growth is starting to slow, but Wall Street still considers it a “growth stock.”  The analysts with “Buy” ratings believe management’s lofty growth targets.  If the company dials down its growth strategy and starts to pay a dividend, naysayers may proclaim that it has “signaled” to investors that it is no longer a growth company; the PE may crumble and kill the stock price (not to mention the value of management’s stock options).  This mentality was prevalent in the 1990s. To avoid that fate, XYZ will be tempted to continue to invest aggressively for growth, perhaps in riskier areas (such as foreign markets) or by making acquisitions.

But if these investments are unsuccessful they will destroy shareholder value and the stock will definitely collapse.  A good example is Starbucks, which in 2006-2008 was building too many stores in order to meet Street revenue growth expectations.  During the recession earnings collapsed, SBUX ended up shutting 500 stores, and the share price dropped 75%.  Oops.

Free Lunch!

Clearly it is preferable for XYZ to recognize that its business is maturing and start to pay a dividend.  This does not mean it is no longer a growth company—merely that its cash flow exceeds reinvestment opportunities.   For example, over the past few years many large, cash-rich tech companies (including Microsoft, Intel, Qualcomm, and Cisco) initiated dividends.  Although this decision may have altered their image on Wall Street, in no case did it prompt analysts to cut their EPS estimates, secular growth rates, or price target on the grounds that the dividend would prevent  the company from funding growth properly.

In effect, then, for shareholders the dividend was literally a “free lunch” – new dividend, same growth rate.   This applies to most large, mature U.S. companies, not just tech.   They can pay a meaningful dividend without hurting EPS growth because they generate more cash flow than they can successfully reinvest .

Intelligently Deploying Free Cash Flow – “Not Doing Too Much”

In our August 3 post refuting Bill Gross’ claim that stocks were a Ponzi scheme, we highlighted the importance of companies using free cash flow to maximize shareholders’ total return. First, some elementary definitions for XYZ Corp.

  • Earnings per share = Net income / shares outstanding
  • Net income + depreciation = cash flow
  • Free cash flow = Cash Flow – (capital spending needed to maintain the growth of the business)

Free cash flow can be deployed in four ways:

  • Pay a dividend
  • Share buy-backs.  If they actually reduce the shares outstanding buy-backs will increase earnings per share and, like dividends, are a “return of capital” to shareholders.
  • Acquisitions
  • Pay Down Debt

Historically firms deployed free cash flow poorly, overinvesting in plant and equipment or making dumb acquisitions.   But in today’s downbeat, sober and sensible financial environment, companies have become smarter in deploying cash. Capital spending is appropriately cautious.  Dividends have been growing rapidly but still are only about 30% of earnings, so there is room for additional rapid DPS growth.  Share buy-backs are fairly strong and are shrinking the share count of the S&P 500 1-3% per year.  Because balance sheets are already strong, debt paydown is not a priority.

By intelligently deploying free cash flow mature firms with fairly slow organic net income growth nevertheless can generate high single-digit total return to shareholders.  As an example, here is a possible combination:

  • Organic net income growth:                                                    4%
  • Plus Additional net income growth from acquisitions:     1%
  • Plus Share buy-backs that shrink share count                     1%
  • Equals Total EPS growth of                                                     6%
  • Plus Dividend Yield of                                                               3%
  • Equals Total Return to Shareholders                                     9%

This is the corporate equivalent of a major league batter who – as Yankee radio commentator Susan Waldman likes  to say – “Didn’t try to do too much.”  Like the batter who settles for an RBI single rather than trying to slam a home run (and probably striking out), managements are deploying cash in a disciplined manner.  Yet a 9% total return is very attractive when 10-year treasuries offer 1.5%.

Reaching for Yield? – Dividend Policies of the Dow Industrials

To see how these principals apply today, let’s look at the payout ratios, dividend growth, and PE ratios of the thirty companies in the Dow Jones Industrial Average.  The key trends:

  • The median dividend yield of the thirty firms is 2.7%.  (The mean is exactly the same.)
  • There is no evidence that the popularity of dividends is prompting companies to pay out too much.  The median dividend payout ratio in 2012 is 37.5%, up only modestly from 34.0% in 2007 when dividends were less sexy.  Considering that these are giant mature companies, 37.5% is still quite low.  The payout ratio in Europe and Asia excluding Japan is 40-45%, and the payout ratio of the S&P 500 (which has many stocks that pay no dividends) was 40-45% in the late 1980s, at a point in the business cycle comparable to 2012.
  • On the other hand, there is good evidence that investors are “reaching for yield” by paying too much for high yielders.  The PE’s of ATT and Verizon are 15.6x and 17.8x, even though they have fairly slow dividend growth of 4% and extremely high payout ratios of 73% and 80% respectively.  Shares of P&G and Coca-Cola also look expensive as investors gravitate toward “defensive” stocks with nice yields.
  • Of the thirty stocks, some that seem to offer an attractive combination of reasonable PE ratios, decent historical DPS growth, and moderate payout ratios include CAT, CVX, INTC, JPM, MSFT, TRV, and XOM.  But these virtues will not prevent them from being bad stocks if their earnings are disappointing.  Although intelligent payout policies can enhance total return, and are evidence that management is sensible and “shareholder friendly,” keep in mind that it is earnings growth and valuation that drive stock prices, not dividends.

Dividends versus Share Buy-backs

We prefer dividends, but both have their uses.  We’ll cover that in a future post.

Update: You can also find this post on Seeking Alpha  http://seekingalpha.com/article/824551-not-doing-too-much-smart-cash-deployment-enhances-total-return

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Why the Marx Brothers Should Support Romney

Posted on August 9, 2012 by tomdoerflinger

I have studied inequality way too much.  I once ruined three months of my life sitting in the Boston Public Library in the 1970s, scanning microfilm of the 1875 Massachusetts State Census returns in order to measure wealth inequality.  I eventually determined conclusively that most citizens had virtually no wealth and a few had a lot.

Which begs the question: So what?  The key driver of Gini Coefficients, the standard measure of inequality, is whether the top people in the income distribution – the top 1%  — are really rich or really, really, really rich.  Whether they have 10% of total income or 20% will drive the Gini coefficient.  Unlike such metrics as unemployment and inflation, Gini is a highly abstract statistic.  If Jane Citizen is sweating on the subway to get to her pathetic $100,000 job in Manhattan, what does it matter to her whether this year Mayor Bloomberg earned $50 million or $500 million?

It may not matter much to Jane, but it matters a lot to three influential, or at least ubiquitous, liberal economists – Robert Reich, Joseph Stiglitz, and Paul Krugman.  Because they are all men of the left, I’ll dub them the Marx Brothers.  Here they are expounding on inequality:

Paul:   “Inequality is a major reason the economy is still so depressed and unemployment so high. . . . the takeover of half our political spectrum by the 0.01 percent is, I’d argue, also responsible for the degradation of our economic discourse.” (May 3, 2012 NYT Column)

Joe bemoans “the large and growing inequality that has left the American social fabric, and the country’s economic sustainability, fraying at the edges: the rich were getting richer, while the rest were facing hardships that seemed inconsonant with the American dream.”

Rob:  “I have never been as concerned as I am now about the future of our democracy, the corrupting effects of big money in our politics, the stridency and demagoguery of the regressive right, and the accumulation of wealth and power at the very top.”

With Mitt Romney in the political spotlight, the Marx Brothers tend to blame Wall Street for inequality. But the Street’s importance is easily exaggerated.  According to an exhaustive study of IRS records, if we look at the income (including capital gains) of the top 1% of Americans, financial executives only earned 13.2% of Americans’ total income in 2005, up from 7.7% in 1979, when Wall Street was depressed.  What about the infamous top 0.1% of income?  The numbers are only a little higher – 17.7%, up from 11.2% in 1979.

Another fallacy of the Marx Brothers is that all the rich guys are on the “regressive right.” Haven’t they noticed that President Obama spends more time in Beverly Hills, Marin County, San Jose, Fairfax County, Westport and the Hamptons than he does in the White House?  F. Scott Fitzgerald was right.  The rich are different from you and me; they don’t need to worry about taxes.

Marx Brothers for Romney?

In any event, the Marx Brothers will be pleased to learn that Mitt Romney has a plan to reduce income inequality in America.  New York Times reporter and liberal lion David Leonhardt recently demonstrated that while the rest of the country is struggling, Washington D.C. is booming:

  • The unemployment rate is 5.7% in D.C. versus 8.3% for the overall U.S.
  • Personal income per household in D.C. is 50% above the national average.
  • “The average house price in the region is more than 10 percent above the 2009 nadir, while nationwide prices remain near a decade-long low.”
  • According to Forbes, of the ten counties with the highest median household income, five are in the Washington area, and another, Los Alamos, also depends on Federal spending.

With Washington flourishing while America is foundering, it is clear that the surge in Federal spending and regulation that enriches bureaucrats, lawyers, lobbyists, and government contractors is a key driver of  income inequality in the U.S.  Therefore, Mitt Romney’s plan to cut Federal spending, repeal Obamacare, liberate fossil fuel from the EPA, and roll back other regulations will take a giant step toward reducing the relentless increase in income inequality that so perturbs the Marx Brothers.  I’m confident that, once they recognize this, the Marx Brothers will become strong supporters of Romney’s candidacy.

On the occupations of top earners, see “Jobs and Income Growth of Top Earners and the Causes of Changing Income Inequality: Evidence from U.S. Tax Return Data” by John Bakija, Adam Cole, and Bradley T. Heim (April, 2012).

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Another Stock Market Buy Signal from Bill Gross?

Posted on August 3, 2012 by tomdoerflinger

Recently Bill Gross, the brilliant “bond king” who  founded Pimco, published a market commentary which The Wall Street Journal summarized with the headline:

Bill Gross:  Stocks Are Dead and Operate Like a ‘Ponzi Scheme’

It sounds ominous, but it could be bullish.  Judging from published reports, the timing of Mr. Gross’s bearish stock market calls has been less than perfect.  A  CNNMoney article dated Sept. 6, 2002 carried this headline:

Gross predicts Dow 5,000.  Influential Pimco bond manager sees stocks moving lower before recovery begins.

CNN reported that Gross expected stocks to fall another 40%.  In fact stocks troughed in September 2002 and rose 22% over the next year, 37% over the next two years, and 87% over the next five years.

Deconstructing the “Cult of Equities”

Nevertheless, Gross’ recent commentary spotlights an issue that merits close attention.  He argues that baby boomers became unduly infatuated with stocks.   They

“. . . grew wealthier believing that pieces of paper representing ‘shares’ of future profits were something more than a conditional IOU that came with risk.  Had not history confirmed it?  Jeremy Siegel’s rather ill-timed book affirming the equity cult, published in the late 1990s, allowed for brief cyclical bear markets, but showered scorn on any heretic willing to question the inevitability of a decade-long period of upside stock market performance compared to the alternatives.”

Mr. Gross is being a bit unfair to Prof. Siegel of the Wharton School, who published Stocks for the Long Run not “in the late 1990s” near the top of the bull market, but rather in 1994.  The latest data points in the book are for 1992, when stocks were languishing during an anemic “jobless recovery.”

Gross’ claim that the equity cult only “allowed for brief cyclical bear markets” is also questionable.  It is well known that stock prices “went nowhere” in the 1930s and 1940s, and again in the 1970s. Indeed, Siegel wrote “Stocks have what economists call mean-reverting returns, meaning that over long periods of time, high returns seem to be followed by periods of low returns and vice versa.”  This is particularly relevant today, because if Siegel is correct then stocks, following poor returns from 2000 to 2012, should be about to enter an extended period of strong performance.

Ponzi Scheme?

The clever title of Gross’ piece, “Cult Figure,” refers to 6.6%.  This is what Jeremy Siegel determined, after exhaustive historical research going back to 1802, to be the “normal” and surprisingly consistent long-term real total return from equities.  Let’s unpack this figure, because the details matter:

  • “Long term” means not five or ten years, but something like fifty years—long enough to even out the lags and lurches in stock prices.
  • These are pre-tax returns.
  • These are real, i.e., after inflation, returns.
  • All dividends are reinvested in the stock market.

The cult figure means if you put $100,000 in a tax-free account, invested it in the S&P 500, and reinvested all the dividends, then after fifty year the purchasing power of the fund should have climbed to $2,442,644.  Not bad, but you do have to wait fifty years before spending a dime.

Gross claims this 6.6% real return is a “Ponzi scheme” because real GDP has only grown 3.5%.  If equity investors get 6.6% “then somehow stockholders must have been skimming 3% off the top each and every year.”  This will be even less sustainable in the future, he claims, for two other reasons:

  • Wages and salaries’ share of U.S. GDP has been declining pretty steadily since 1960 while corporate profits’ share has increased, and that can’t go on forever.
  • Effective corporate tax rates have been declining, and that can’t go on forever either.

Mr. Market Is Not Bernie Madoff

It seems implausible that equity investors somehow managed to get 310 basis points of spurious returns per year, and did so for over a century.  In fact, they didn’t.  The mistake in Gross’ reasoning, as Henry Blodgett points out, is that he is ignoring dividends.  He is confusing “stock market appreciation” with “total return” which includes reinvestment of dividends.

Another big conceptual flaw in Gross’ reasoning is that the S&P 500 is not coterminous with the U.S. economy.  Fully one third of the S&P 500 is outside the U.S., and even the domestic portion of the index is only a fairly small segment of the U.S. economy and a segment that is much more concentrated in high-tech, high-productivity growth parts of the U.S. economy.  (To get a feel for what I mean, wander into your local town and look around.  You will see hundreds of businesses, employing thousands of people, that are not in the S&P 500.  Most of them are labor-intensive service businesses with low productivity growth.)

Future of the “Cult Figure”

With 10-year treasuries  delivering a real yield of minus 0.5% (1.5% minus 2% inflation), the equity cult figure does not have to be as high as 6.6% to be attractive.  It may well turn out to be lower, but this is not inevitable by any means.  It is worth pointing out that Mr. Gross and his Pimco colleagues have been mostly wrong in expecting poor profit growth during the post-financial crisis “new normal” era.  S&P 500 profits have doubled from their third quarter 2009 low, on a pro forma, rolling four quarter basis – despite egregious mismanagement of the U.S. and European economies.  Some of the factors that will determine whether stocks manage to maintain their 6.6% cult figure are:

  • Do U.S. firms intelligently use their free cash flow to boost shareholder return via dividends, buy-backs, and M&A?  More on that in a future post.
  • Does the U.S. remain a capitalist country or slip into European-style socialism with a stagnant private economy?
  • Does U.S. population grow at a fairly healthy clip, partly via increased immigration geared toward economic growth?
  • Do large U.S. firms continue to prosper in foreign markets?  For example, judging from its disastrous power blackout hitting 600 million people, India could use a bit more help from the likes of GE, Eaton, and IBM.
  • Does the European economy implode and stagnate, or rediscover capitalism and regain the economic vigor it had in the 1950s and 1960s?
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