Discounting The Future

“Why should we invest our money in our own business?” askeda business partner recently, “We could make more money in the stock market.”

The publishing business has not been a high-growth, high profit industry in recent years. We have the opportunity to extend ourproduct lines, or buy new ones, but the return on investment may be as low as 5%.

“It doesn’t make sense,” was the obvious conclusion, one that must have been reached by thousands of business people over the last few years.

I am grappling with a subtle, but important, point. The marketdiscounts future earnings. The discount rate is the equivalent of society’s ‘hurdle rate’ – the minumum return you need from an investment to make it worth doing. The hurdle rate is usually roughly the same as the riskless rate of return that you can get from, say, T-bonds. If an investment won’t do at least that well – why bother?

But stocks return 10% to 15% per year. Those numbers are taken as a minimum by investors and a benchmark by analysts. It ispresumed that there will be periods – from a few months to a few years– in which stocks underperform the longterm averages. But, “over the long run,” the mantra goes, “nothing beats a well-balanced portfolio of equities.”

There is short term volatility, we are told, but no real risk if you are willing to wait out the down periods. Thus, the return fromstocks has come to be regarded as ‘riskless’ – and establishesa new a ‘hurdle rate’ for comparative investment.

But at that rate of return, relatively few capital investments measure up. If you can build an office building and get only an 8% return – what would be the point? You could earn more bydoing nothing.

Over the last few years, companies discovered that they could earn more money buying the stock of other companies than theycan by developing their own business. And what better stock to buy than your own? Not only do you earn money from the general rise in stock prices, your buying helps to drive up the price, whichcoincidentally helps to put your own executive bonus options inthe money.

Occasionally, corporations earned more from the increase inshare prices than they earned from operations. IBM, to use oneexample, has been a massive purchaser of its own shares – spending more money buying IBM shares than the company earned.

However, a company does not become a better company – with new and better products – by buying stock. It becomes a better company by developing its product line. So while IBMused its cash to bid up its own share price, the actual value of the company (at least, theoretically) must have declined.

If a company really could earn more from share buying than itcould from operating, it would not only buy a few shares fromtime to time, it would fire its workers, lock the doors – and putall the money to work in the stock market.

As Mark Hulbert puts it in his piece in the NY TIMES, “If the market’s expected return is greater than a company’s return on equity, the rational thing for the company to do is to close up shop and invest its assets in the stock market.”

Over the long run, stock market price increases cannot exceed corporate earnings. Otherwise, the companies would disappear – their capital values liquidated so owners could participatemore fully in the stock market.

Disappear might be the right word. Because a company that can’t produce a return on equity equal to risk free rate of return is not an asset – it’s a liability.

You find the value of a company by discounting (using the prevailing discount rate) the stream of income it is expected to produce. If the discount rate is greater than the return on equity, the capital value is negative. It has no value…or actually, negative value…since an investor could make more money in arisk-free, discount-rate placement.

Any company that has not made at least as much return on equity as the average return from stocks should have been sold off.Yet, one of the strange trends of the last few years has beenfor stock in companies with negative capital value (that is,companies that are not likely to produce enough income to exceed the hurdle rate of return) to rise in price. This, of course, cannot persist.

Two professors – Eugene Fama at the University of Chicago and Ken French of MIT – have been researching the long-term returns from stocks. They discovered that, for the last 50 years, corporations have been earning 11.9% on equity. But the stockmarket average has been increasing at 14.8%. How could that be?How come businesses knock themselves out for a 11.9% return, when the owners could have gotten 3% more without any real effort?How could America’s corporations have been unprofitable, on a discounted basis, for half a century? Or, how is it possiblethat all the publicly-traded businesses in America would have, again discounted by the ‘risk free’ returns of the stock market to net present value, a negative value?

The professors answer the question by saying that stock market investors erred. They overestimated the gains the stock marketshould produce. The expected rate of return from stocks, say the academic duo, should be more than 5 points lower than most people think.

Looking further back, Fama and French discovered that the stock market returned an average of 8.8% for the 70 years from 1872 to 1949. They believe that period was more representative of the market’s true capacity to reward investors. Their work has not yet been published, says Hulbert, but “word of it isbeginning to spread.” More on the mysteries of the discount rate…soon.

Your correspondent,

Bill Bonner

Paris, France June 6, 2000

P.S. I am the victim of a new syndrome…yet to be picked up by TIME or by the talk show circuit: road rage on the information highway.

Mark Hulbert wrote a piece in the NY TIMES on Sunday, which I had clipped. But between the time I read it and this morning, when I needed to refer to it for this article, the articlewas lost.

So, I asked my assistant, Addison, to go to the NY TIMES website to retrieve the article.

Easier said than done. The website asked for our zip code which, once given, was refused as “incorrect.” We were sure it was the right zip code, but we tried a few others too. Nozip codes were accepted. So we were unable to pay $2.50for the article.

So, we tried the International Herald Tribune website. IHT had run the article too. And IHT doesn’t charge to view articles, so we would thus avoid the zip code trap. This, too, proved unavailing. The article which appeared in Monday’s paper, forwhatever reason, was not included among the articles that supposedly appeared in Monday’s paper.

Finally, Addison picked up the phone and called the librarian at the IHT office across town. “No problem,” said she, “just email me with what you want and I’ll email it to you.” After another phone to chase it up…the article finally arrived.

Things don’t always happen the way they’re s’posed to. Andtime is precious. That is why a dollar in the future is worth less than a dollar today. How much less? That’s what the discount rate tells us.

And “in the long run,” said the economist John Maynard Keynes, whose birthday we celebrated yesterday, “we are all dead.” So, if you’re going to do something important, or something you want to do, you’d better do it now rather than in the future.Who knows what the future will bring?

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*** Richard Russelltells us that the halfway point between the Dow’s most recent high and its most recent low is a critical level. He calls it the “50% Principle.” If after making a low, the Dow can recover 50% of its losses – and hold above that level – there is a good chance it will continue to rise.

*** Yesterday, the Dow rose 20 points – bringing it decisively above the halfway point of 10,759. Can it hold? We’ll see.Does it matter? Who knows…but it adds a little drama toour daily review of the numbers.

*** Last week’s great bull explosion sputtered on Monday. The Dow and Nasdaq still had enough momentum to end the day in positive territory. But the advance/decline line fell back into loss – with 1329 stocks advancing on the NYSE and 1625 declining.

*** The price of gold continued to rise yesterday – up $4. Gold, as explained in a research report by Paul van Eeden, varies inversely with the foreign exchange value of the dollar. The dollar goes down… gold goes up.

*** So, the dollar fell yesterday…a very ominous trend, in my view. Every major sector and indicator of the bull market has topped out – including most recently, the Nasdaq.Et tu, greenback?

*** The euro rose against the dollar to a value of nearly 95 cents. A few days ago, financial journalists pronounced the euro dead. They may have been a bit premature. In fact, it may be the dollar that is ailing. If so – the US economy and its stock market will soon be infected.

*** The end of the bull market could be the biggest financial story never reported (except here). It would make imports more expensive and, thereby, begin the work of reducing thecurrent account deficit.

*** Working on Wall Street was not always the high-earning,high prestige career it is today. After the bear market of ’73-’74,the Charles Schwab Corp. was in trouble. It had only 13 employees,many of whom were looking for other jobs. But the 80s and 90swere good to Schwab. It grew to 356 domestic offices, 7 million accounts, $823 billion in customer assets and a market capof nearly $40 billion. But now, volume is falling and at least onecompany is offering to do stock trades for free. Schwab and the other discount brokers are being squeezed. Schwab’s shareprice fell to 32 ½ yesterday.

*** Optimism dies hard. Bill King reports that Jose Conseco,baseball and stock market player, was on CNBC talking about his investments. He is 90% in tech stocks and expects theNasdaq to hit 5,000 within 8 months. King opines that perhaps Conseco’s judgement was impaired by the homer that “caroomed off his coconut.”

*** Speaking of infections, there’s a strange infection afflicting heroin users in Glasgow. Women drug addicts seem to develop abcesses and then about half of them die. Health authorities believe the infection may be a type of anthrax poisoning.

*** “A prolongation of the resistance would make for a useless loss of blood,” wrote General Erwin Rommel to the besieged Free French forces at Bir Hakeim, North Africa, 58 years ago.“You will suffer the same fate as the 2 English brigades that were annihilated at Got Saleb the day before yesterday.” The French refused to surrender. The Italian and German armies attacked, but the French held out, miraculously, until theywere relieved.

*** Today is, of course, also the anniversary of the Normandy landings in WWII.