Foolish Four Portfolio
Dow 36,000?
By
And we're ready for it!
Alexandria, VA (September 10, 1999) -- Remember the "Greater fool" theory? A surprising number of investors apparently believe that the way one makes money investing in stocks is by buying them and then selling them to someone who is a "greater fool" and is thus willing to pay even more for them than they did.
While that is undoubtedly true in some cases, most often when one buys a stock that isn't worth what one pays for it, no convenient "greater fool" shows up. That's how you lose money investing in stocks.
But that isn't how the market really works. There are very rational reasons for buying stocks, reasons that drive the market, even if many investors don't realize it. The reason is simple actually: stocks pay out cash. I can hear it now -- "Wait a minute!" you are saying. "Yes the Foolish Four pays out cash, but what about all those hot Internet stocks? What about Visx <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VISX)") else Response.Write("(Nasdaq: VISX)") end if %> and Qualcomm <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: QCOM)") else Response.Write("(Nasdaq: QCOM)") end if %> and Amgen <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMGN)") else Response.Write("(Nasdaq: AMGN)") end if %>? Do they run on the "greater fool" theory? What about Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> for crying out loud!"
None of these wonderful stocks pays a penny in dividends. All of their cash is going back into building their business. But one day -- and Microsoft, with $20 billion in cash, is getting close -- these companies will move from their high growth phase into maturity. Growth companies don't usually pay dividends; mature companies generally do. Those dividends will be x percent of their earnings and so it is to the investor's advantage right now for those earnings to be growing at the fastest possible clip.
Which brings us to the second half of our discussion of Dow 36,000, a significant new theory of stock market performance by James K. Glassman and Kevin A. Hassett appearing in this month's Atlantic Monthly. We started our discussion of this article yesterday and, as I said then, it is well worth reading in its entirety. Today we take on sections 2 and 3.
[Mathphobe Alert: The second part of the series is the numbers part. I know that you tend to skim over that part, but let me suggest that reading part 2 with a pencil and paper (or calculator) handy, and actually taking in those numbers, will be an effort well worth making. It's simple stuff, really, nothing beyond fourth grade math. You can do it!]
The essence of Glassman and Hassett's argument is that even the fastest growing company starts paying dividends, eventually, if it continues to be successful, and those future dividends are going to put a lot of cash in shareholder's pockets, eventually. The price of a share of stock is ultimately tied to this reality. Capital gains (or, in other words, share price increases) are the way investors bid for the rights to those eventual dividends.
The third, and in my mind most interesting part of the series, is subtitled, "The Decline of the Risk Premium." If you don't read the whole article, this is the one section you might want to peruse. It's the last half of part 3.
The term "paradigm shift" has suffered from overuse. Too bad, I'd like to trot it out and use it to describe what Glassman and Hassett believe is happening, but it has become too trite. I have to give the authors credit for journalistic restraint in avoiding the term in favor of a "shift in perception." And perhaps that is all that it is.
But it is a shift with far reaching consequences, a shift that explains a lot.
Back in Finance 301, we learned a formula for expected rates of return. It included something called a risk premium -- that is, an increase in the rate of return that investors demand, a premium to compensate for their perception of how much risk is involved in the investment. Essentially, this risk premium explains the difference in the returns generated by stocks vs. the returns generated by bonds. Investors felt that stocks were more risky and therefore the rate of return that would entice an investor to invest in stocks vs. bonds had to be higher.
But investors are changing their perceptions -- and for a very rational reason. As we discussed yesterday, stocks, in general and over the long term, are not more risky than bonds. Rather than an irrationally exuberant market, investors have been demanding an irrationally high risk premium for investing in stocks.
As investors change their minds about the long-term riskiness of stock investing, the risk premium has been coming down. THAT in a nutshell is why stock prices have been rising toward parity with bonds. There is still a long way to go before we get even close, though, and that is what will keep the stock market healthy for years to come.
Yeah, they convinced me. :)
Fool on and prosper!