Friday, October 16, 2009

John Burr Williams' Lament

John Burr Williams is widely credited as being the father of dividend investing and the creator of the forerunner of today's dividend discount models. Williams was also a first rate economic strategist.

Williams was already a successful Wall Street investor, when in 1937 he went back to Harvard. Williams sought to earn his PhD in Economics with the hopes of learning what had caused the stock market crash of 1929 and the subsequent economic depression of the 1930s. By the end of his time at Harvard, Williams had concluded that the primary causes of the depression were high stock market volatility, which he believed was caused by a lack of an accurate method for valuing stocks; and ill-conceived government actions and inactions in the economy.

Williams’ doctoral dissertation, which was published as a book, was entitled “The Theory of Investment Value.” In it he explained that the prevailing (then and now) method of determining the value of a company by analyzing earnings was inherently inaccurate. Instead, he urged, that dividends should be the primary determinant of a stock’s value because dividend payments were far less volatile than earnings.

The following is a brief excerpt of the formula, which would later become known as the dividend discount model, that Williams proposed as a more accurate method for valuing stocks.

“The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [risk less] interest rate demanded by the investor.”

Williams’ Lament:

Williams' lament was that the volatility of the stock market in the 1930s was not justified by the long-run dividend growth prospects of the underlying companies. But because most investors focused on short-term earnings and not long-run dividends, they got caught up in running from and chasing after illusory earnings-driven prices. In doing so, they met themselves coming and going and began to question whether or not there was a true underlying or intrinsic value to stocks. When they came to this conclusion, it was only a matter of time before they were willing to turn the whole thing over to the government.

Williams believed that in abandoning the free markets in favor of more government control of the economy, investors helped usher in a period of sub par growth for the economy and share prices. He explained that the government is neither a good allocator of capital nor is it geared toward innovation. In his mind, where there was a lack of efficient capital allocation, there would be a shortage of innovation, and where there was a shortage of innovation there would be a shortage of growth and profits.

Williams’ also voiced great skepticism toward the theories of John Maynard Keynes and President Franklin Roosevelt's "New Deal," both of which promoted the idea that government spending could lead to prosperity. Williams was convinced that the government’s “mismanagement” of the economy was partly responsible for the depression of the early 1930s.

While his disdain for the theories of Keynes was universally criticized by the dons of Harvard, Wall Street, at first, ignored Williams’ book, not realizing that he took aim at them in its pages, as well. Eventually, however, the investment elite were to learn that Williams’ heaped some of the responsibility for the depression of the 1930s on them.

“The wide changes in stock prices during the last eight years, when prices fell by 80% to 90% from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practices in Investment Analysis [Wall Street]. Had there been any general agreement among analysts themselves concerning the proper criteria of value, such enormous fluctuations should not have occurred, because the long- run prospects for dividends have not, in fact, changed as much as prices have. Prices have been based too much on current earning power, too little on long-run dividend-paying power. Is not one cause of the past volatility of stocks a lack of a sound Theory of Investment Value? Since this volatility of stocks helps in turn to make the business cycle itself more severe, may not advances in Investment Analysis prove a real help in reducing the damage done by the cycle?”

If John Burr Williams were alive today, he would be, undoubtedly, be lamenting the markets' volatility over the past three years and its effect on the economy. During this time, the Dow Jones Industrial Average rose from about 11,000 to near 14,000, then collapsed to near 6,500, before rallying recently to just over 10,000. He would say (as we would) that during this time the long-run dividend paying ability of companies did not fluctuate nearly as much as did either earnings or prices. He would also say that in light of this stock market volatility and its impact on the the economy, it is not surprising that the citizens of this country are questioning the merits of the free markets. However, he would also be warning anyone who would listen that to think that the government can produce sustainable economic growth is an illusion. He would point to the 1930s and remind us of the last time that the government sought to supplant the private sector in stimulating economic growth. It didn't work and there is not much optimism that it will work this time either.

It is because of the slow-growth environment that we see unfolding in the US, that we have been moving more and more of our clients’ assets to stocks either domiciled outside the US, or domestic companies that do a preponderance of their business in developing nations. This move to more international stocks is still focused in high quality companies that have a history of sharing their prosperity with their shareholders through dividends. Indeed, it is this dividend-history that, as John Burr Williams would say, shows us where the values are.