FOOLISH FOUR PORTFOLIO
Financial Education in a Nutshell
By
Why stocks are not overpriced
RESTON, VA (September 9, 1999) -- Have you ever read something and thought, "Darn, I wish I'd written that"? I do all the time, but I've got a particularly bad case of it right now.
My fit of envy is over an article in the Atlantic Monthly written by James K. Glassman and Kevin A. Hassett. Glassman used to write the only financial column I read regularly. It was in the Sunday Washington Post and was, if I dare say it, very Foolish. He has gone on to other things, and if this article in the Atlantic Monthly is a sample, we may all be better off for it.
The article is called "Dow 36,000" and is from an upcoming book of the same name. I'm glad I knew Mr. Glassman before I noticed the title of the article -- I tend to dismiss out of hand anything that purports to predict the market. But this one is different. Glassman and Hassett aren't trying to time the market or even to predict when it will hit a certain point (at least not in the article). They are offering a cohesive account of why stocks are worth, in cold economic terms, considerably more than they are selling for today.
There are three main points, and I will summarize them here today and tomorrow, although I strongly suggest that you click over to the article and read the details yourself as well. The going might get a bit heavy at times, but it's worth it.
The first point is that stocks are actually less risky, in the long term, than bonds. Whoa! The second point is that, contrary to popular (and scaremongering) opinion, stocks today are underpriced. The third is that investors are putting these two facts together and coming to an inescapable conclusion that is driving this amazing market upward year after unprecedented year.
The first big idea you have to swallow is that stocks are less risky than bonds -- over the long term. This flies in the face of traditional financial counseling, but as I read through the specific examples and arguments that Glassman and Hassett make, things that I had been observing and wondering about for years all fell into place.
If stocks are so risky, why have all studies shown that they consistently outperform bonds? OK, they are more volatile, and for someone who needs to take money out of an investment at a specific time, volatility can be a killer, but for your long-term money, what is the point in splitting your portfolio up among stocks, bonds, and cash?
More and more I have come to see that the point is to sell financial services -- portfolio allocation models that only the Wise can interpret. Only the Wise can tell you when to switch from an allocation of 60% stocks, 30% bonds and 10% cash to 55% stocks, 25% bonds and 20% cash. People have been following such models for years, and they have made money, and perhaps they've slept better thinking that their money was safer, but almost all of them have made significantly less (and paid out significantly more) than if they had just stuck all of their money in an index mutual fund.
Please remember, the above only applies to long-term money. And it only applies to folks who have the stomach to keep the faith when times are bad. Selling when the market is down is probably the biggest contributor to that big, bad, risky reputation stocks have. And it only applies to a diversified group of stocks, not individual issues. Keeping those things in mind, let's continue.
Here's a key paragraph from the article:
"Over a twenty-year period the worst inflation-adjusted return by stocks was an annual average of 1.0 percent. For bonds, however, the worst was -3.1 percent, and for T-bills -3.0 percent. Over one-year periods stocks have outperformed bonds only 61 percent of the time, but stocks beat bonds 92 percent of the time over twenty-year periods and 99 percent of the time over thirty-year periods."
Those are good odds.
In investing, the most difficult question to answer has always been: What is the actual fair market value of a share of stock? There are dozens, if not hundreds, of formulas around if you want to price stocks. Like the famous PE, many of them assume that some multiple, or range of multiples, times the stock's earnings or dividend yield is a good way to arrive at a fair price. But those multiples are based on historical averages.
Glassman and Hassett actually use elements of a more academic model. Based on the pricing model used for bonds every day, they suggest that the price of a share of stock should be equal to the present value of all future cash flows from it. That's not particularly revolutionary. My Finance 301 book says the same thing. The revolutionary part is in the formula for present value.
The present value of a stream of income is defined as the sum of each future cash payment, discounted by the rate that you could get for an investment in some alternate investment -- often a theoretically risk-free investment.
Here's a quick example: Say you knew you would be guaranteed a payment of $1000 in 10 years. What would you pay for that right now? Well, you could buy a good quality zero coupon bond that paid $1000 in 10 years for about $780 right now, assuming a 6% interest rate. (Zero coupon bonds don't pay interest in the traditional sense -- you pay less than the face value of the bond up front, then you collect the full face value at maturity.) So the present value of that bond is $780. If you assume a higher interest rate, the present value goes down and vice versa.
So in valuing stocks, we say that one fair value is the present value of all future cash payments, meaning dividends plus any capital gains when you sell. Glassman and Hassett use the idea of a perpetual bond (they exist) that pays only interest, as a substitute for a buy and hold stock. In that case the future capital gain is ignored and the stock is simply valued on its stream of dividends. This isn't as strange as it sounds. You aren't really counting dividends through the end of the next millennium. After a while the present value of far-off dividends is close enough to 0 that it doesn't affect the price of the stock very much.
But what do you assume for dividends? Unlike bonds and savings accounts, stocks don't pay a set rate. As a company grows, the amount of money it has to share with its owners grows, too. Strong companies can increase their dividends far faster than the rate of inflation. And that is one of the keys to understanding what a share of stock is worth.
I will go into that tomorrow in more detail, as well as discuss stocks that don't pay dividends, but if you want a preview on both of those issues, you can check out these articles:
First Quarter Dividend Review
The Dark Side of Dividends
Both Sides Now
Dividends Recap
Final Word on Dividends
It's a rather nice series. I wish I'd written it. Oh, wait a minute -- I did!
Fool on and prosper!