John Burr Williams: Investing Versus Speculating

John Burr Williams believed that the stock market was far more volatile than the long-run dividend paying abilities of the underlying companies would justify. This fixation with the short-term, led to periods of gross over and undervaluation in stocks, which, in turn, led to booms and busts in the economy. Williams believed that the cycle of booms and busts caused many people to lose faith in the free market economy and the markets, which ultimately led to the socialist-like economic policies of the 1930s. His book was not about beating the market, or getting rich in the market, it was really a wake-up call to the investment elite of his time to offer them a theory of investment value that would encourage more long-term investing and less speculation. Williams realized that speculators would always be with us, and were a legitimate enterprise, but he wanted to provide tools for investors to aid them in making decisions based on the “investment value” of a company, not just its price momentum. Williams postulated that investors’ inability to properly value stocks, increasingly, led them to become speculators. Most people would not admit that they were speculators, but when they were asked to explain their buy and sell decisions, it was clear that they were not appraising the intrinsic value of companies, but betting that they knew something that the market did not. In one of Williams’s most insightful observations, he makes the following statement: “To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . . Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment. Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either cheat in the matter, or study the forces at work. Cheating has been outlawed, so far as can be, by the Security Act of 1934. The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ‘’coming events cast their shadows before.’ But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator. Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late. That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever. Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.” John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).” This is the sum total, essence, bottom line, and raison d'etre of Donaldson Capital Management. Long-term values of companies are determinined by what you can get out of them. That is why we scrutinize dividend levels and dividend growth. This is where value is created. This is where value can be measured. Finally, this is where we can find opportunties. Opportunities that are being shunned because today's news is not positive or is murky, but opportunities that have already discounted all the bad news and now stand ready to rise, driven by the intrinsic value of the company. Amen

The Fed Still Listens to Mr. Greenspan

As expected, the Fed just announced that they are leaving interest rates unchanged. What did bring a smile to the markets' and to former Fed Chairman, Alan Greenspan's lips, was the very slight change the Fed made to their "leaning" language. For the last six months, they have proclaimed a balanced attitude between the forces of inflation and economic growth, and that "leaning" caused them to end their long string of rates hikes. In today's announcement, their "leaning" language shifted ever so slightly to more concern about slowing economic growth than inflation. As I said in my last post, that is what Alan Greenspan has been advocating, and, apparently, Mr. Greenspan's former charges were looking at the same economic data he was. Even this morning, I read where several noted economists were advocating a rate hike because of the high core CPI rates. They don't live in the real world. The economy has entered a slowing phase which often causes inflation to blip higher because of lost productivity. Thus, to look only at inflation statistics is to look in the rear view mirror. The real picture is being played out in the unfolding crisis in the subprime lending arena. The Fed and Mr. Greenspan know that this crisis will spillover in some way at some level into the prime real estate market and slow the overall economy. Remember this: Greenspan does not use one of those fancy GPS navigational instruments to pilot his car. He watches the road. The road is a lot more unforgiving and confounding than the GPS map, which does not show pot holes, stoplights, or other two-ton cars that may have lost their way. I believe the Fed has now signalled that they will soon cut rates. This poses a conundrum. The economic news and corporate earnings are likely to soften over the next year, but US stock prices are likely to continue rallying. Just as core CPI lags the actual underlying trend of inflation, US GDP growth lags changes in interest rates. If the Fed is poised to cut rates, that will be favorable for stocks even if the economy and earnings begin to slip.

What is Greenspan Really Worried About?

A casual glance at the financial headlines this past week might have lead a person to conclude that Alan Greenspan was still Chairman of the Federal Reserve and Ben Bernanke was still giving lectures at Princeton U. The financial pages were full of Greenspan speaking on a wide range of matters related to the US economy. Significantly, he has had almost a quote a day on the subprime mortage crisis and how it relates to the overall real estate market and, ultimately, to the overall economy. I have spent most of my professional life trying to learn "Greenspeak." I claim no fluency in this arcane language, but I have have picked up an understanding of a few of its words and principles. The main thing to understand about Mr. Greenspan is that his primary goal in his public statements is to initiate debate, shape it, or correct it. Do not make the mistake of thinking that he is talking in some attempt to remain in the spotlight. He knows his place in history is secure. In my mind, if he is talking, it is because his take on the economy is different from the consensus. Here is a short list of what I think Mr. Greenspan is trying to say by his recent public comments.

1. He genuinely believes the subprime real estates woes will spill over into the prime real estate market, at some level.
2. Although there is no evidence, yet, the poor real estate market will slow the overall economy, perhaps, into negative territory.
3. He believes the primary problem the Federal Reserve should be addressing is economic growth and not inflation.
4. If the Fed waits for core CPI to fall to the comfort level before starting to cut rates, they risk letting recession take hold.
5. A time to "break the rules" is at hand. The Fed must have the boldness to start cutting rates when the economy appears to be growing at its optimal level and core CPI is above the comfort level.
6. He is doing this because he does not believe there is a consensus for this action either in the market or at the Fed.
7. Finally, heaven forbid, that the Fed should hike rates to fight inflation in the face of the coming economic slow down.

Mr. Bernanke and his fellow members of the Federal Reserve are meeting this week. We'll listen carefully to their official statement. If it is primarily aimed at fighting inflation, I have the strong feeling that Mr. Greenspan will stay on the offensive. If they emphasize that economic growth prospects appear to be dimming, I think Mr. Greenspan will stand down.

Seeing Through the Smoke and Noise

The stock market fell sharply again today on weak retail sales and continued worries about the subprime mortgage market. The air is getting thick with worries: Weakening US economic data, Mr. Greenspan’s utterance of the “R-word,” and bad news in the real estate market. When economic worries begin to mount, I believe the best way to understand the “real” economic risks in the markets is to ask the question of each problem, ”Whose lap is this situation ultimately going to fall in?” If the wallet that is in the hip pocket of that lap is financially loaded, the problem will be solved in a short time. If the wallet doesn’t have much in it but family pictures and a maxed out credit card, the problem will keep going and growing. Here’s the shortlist of the problems and my analysis of whose lap the problem is headed toward. 1. Over the past week, there has been a string of weaker US economic data. GDP is now tracking just about 2%, down from earlier reports of over 3%. Retails sales were weaker than expected, job growth was muted, and the capital goods sector appears to have slowed sharply. This slow-down in the US economy is the natural result of the Fed’s string of rate hikes. When interest rates go up, it is a form of a price hike, and under the law of supply and demand, higher prices, ultimately, lead to a softening in demand. The Fed had a major responsibility for putting the brakes on the economy to slow inflation, and by law, they have the responsibility to deal with the slowdown by cutting rates. I have been back and forth on when the rates cuts will happen, but I have remained steadfast in saying that real estate problems would, ultimately, be the driver of lower rates. 2. Ex-Fed Chairman, Alan Greenspan, said in a speech in Hong Kong that he thought there was a 33% chance of a recession in the US. Those odds were much higher than Wall Street estimates, and as a result, he has been roundly criticized for sticking his nose where it doesn’t belong. As I have thought about it, I believe Mr. Greenspan might have been speaking directly to Ben Bernanke and his cohorts at the Federal Reserve, advising them that they cannot wait until they actually see a fall in inflationary data before cutting rates. That is the old lagging Fed policy that Mr. Greenspan exposed as a failing strategy during his 18 years on the job. The Fed has to lead, and in this case, that means cutting rates before improved inflation data are evident. I believe the real risk in the US and world economy is just this: Will Bernanke and the Fed have the nerve to lead, by cutting rates soon, or will they employ the lagging policy that lead to booms and busts in the 40 years prior to Greenspan. I believe Mr. Greenspan was saying “pay attention boys and girls. Don’t just watch the data, get out and kick the tires. See if they are moving, or parked in the back lot.” 3. Real Estate worries: For the last 9 months, my contention has been that real estate was in worse shape than the public perception. The subprime market is a small piece of the US mortgage market and the troubles there would not seem to be causing such a row in the overall market. Here’s the bottom line on why the subprime market is important. The capital the subprime lenders loaned to their high-risk customers was borrowed from big mortgage and investment banks. The real worry that is now gripping the market is: how much of this high-risk debt do the big banks have and who has it? In my mind, this is the easiest of the issues to answer. Major US banks and investment banking houses are in the best financial shape they have been in since before the savings and loan crisis of the early 1990s. The subprime loan problems are not big enough to cause permanent damage to the majority of major US and international banks. Subprime troubles will continue to fill the headlines, but the lap they are falling into (the big banks) has a wallet that can easily handle the losses. The stock market is jittery and will continue to bounce around, but let me remind all of you dividend investors: Your income is unchanged; indeed, there is the strong probability that it will grow in the year ahead. Bouncing stocks are speculators tossing them back and forth for the sport of it. The intrinsic values of your companies are not changed by the headlines and the prognostications of this trader or that stock market guru. The intrinsic values of your companies are determined by how well our companies can execute their business strategies and how much of their profits their boards of directors decide to share with you. We have carefully chosen companies that have a steady hand and have an ironclad history of writing dividend checks that mirror their profits. As I stated in my most recent blog, John Burr Williams and Arnold Bernhard were convinced that the stock market was much more volatile than the underlying value of the average company. These two giants of the investment business complained about market volatility and tried in every way they knew how to help people see through the smoke and noise of stock market volatility to the true value of stock. That is our mission, as well. History has proved that Mr. Williams’ and Mr. Bernhard’s theories of valuation were correct, but most investors still refuse to take the time to do the math. If they did, they would find a lot of bargains today.

John Burr Williams and the Theory of Investment Value, Part 2

Mr. Bernhard was echoing Williams in pointing out the need for generally accepted criteria to value stocks. He also joined Williams in warning that the effect of not having such criteria resulted in excess stock market and economic volatility, which damaged investor confidence not only in the stock market but also in the free markets. Bernhard then boldly states, “In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock. Whenever, over a period of years, the dividend, or the ability to pay dividends, went up, so too did the price of the stock. When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.” In applauding Williams’s theory, however, Bernhard inserted a subtle twist to Williams’s basic premise by adding the words, “the dividend, or the ability to pay dividends.” By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value. Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist. He is famous for saying that investing is easy: “just buy wonderful companies at good to great prices.” When asked to explain what good to great prices means, he credits John Burr Williams’s formula for intrinsic value, but defines it with a different twist: “The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.” Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings. Neither Buffett nor Bernhard nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said. Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his thesis a section titled “A Chapter for Skeptics.” There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company..” Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following: “Earnings are a means to an end, and the means should not be mistaken for the ends. In short, a stock is worth only what you can get out of it.” [Italics are the author’s.] He then added the following poem: “ Even so, the old farmer said to his son: A cow for her milk, A hen for her eggs, And a stock, by heck, For its dividends. An orchard for fruit Bees for their honey, And stocks, besides, For their dividends. The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.” In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets. Williams answered this issue with the following statement, “The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading, and dividends for years to come, not income for the moment only.” John Burr Williams struck a bright line between being in the chicken business and being in the egg business. He believed, as we will see later, that buying and selling chickens had no predictor and thus was pure speculation. On the other hand, investing in egg-laying chickens was completely different. It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.

John Burr Williams and the Theory of Investment Value

Because we have long espoused John Burr Williams' theories of dividend investing, we are often asked why he focused on dividends and not on earnings in determining a stock's value.  This prioritizing of dividends ahead of earnings was controversial in 1937 when he published his book, and it remains so today.  

This is Part 1 of series of three blogs in which we will describe who John Burr Williams was, why he believed dividends trumped earnings in determining the intrinsic value of a company, and finally, why his theories matter so much today.

In 1937 near the end of the worst bear market in US history, Williams, a thirty-five year old Harvard doctoral student in economics, made the following statement in his thesis: “The investment value of a stock is the present worth of all future dividends to be paid upon it . . . discounted at the pure [riskless] interest rate demanded by the investor.” 

Mr. Williams’ dissertation, entitled “The Theory of Investment Value,” did not immediately earn him his doctorate. That would not be forthcoming until 1940.  Prior to his final oral exam, he sold the rights to his thesis to Harvard University Press, who published his dissertation as a book, but only with Mr. Williams subsidizing a portion of the costs. 

It would seem that only foolish greed could compel a doctoral student to sell his thesis before he had been granted the degree. Williams, however, who was already a successful Wall Street investor when he went back to Harvard, explained that he had returned to college to learn what had caused the 1930s stock market crash (and the subsequent economic depression) from the best minds possible. Since he had come for the knowledge and not the degree and since his work was complete, he wanted to share his findings with the public as quickly as possible. 

What he did not say at the time, but would later admit, was that because of some of the views he had expressed in his thesis, he had become persona non-grata with key Harvard professors and was unlikely to have been awarded the degree anyway. 

Blaming the Bureaucrats 

His troubles with the dons of the school of economics were many but were centered in two areas: (1) Williams claimed that the correct method of determining the intrinsic value of a company was by calculating the present value of its future dividend payments, not earnings as was the universal belief at the time, and (2) he voiced great skepticism of the theories of John Maynard Keynes and the state-sponsored programs of President Franklin Roosevelt. Williams devotes an entire chapter in the book entitled "Taxes and Socialism" to debunking the notion that the redistribution of wealth could lead a country to prosperity.

Finally, in 1940, with the book drawing praise from important financial commentators, and his success as an investor gaining accolades, John Burr Williams went before the Harvard dons to seek his doctorate. 

As expected, he was soundly criticized for publishing the thesis before he had obtained his doctorate, and his professors were upset that he did not embrace Keynes’s teachings. Oddly enough, however, they did not dispute his dividend-centric theory of investment value but questioned if a thesis studying the valuation of stocks was of enough significance to justify a doctorate in economics from Harvard.  After a heated debate he was granted his doctorate. 

The truth is often born of travail, matures under constant testing, and once acknowledged, is subject to twisting. That has certainly been the case with John Burr Williams’ theory. What had angered his Harvard professors, at first, caused Wall Street brokers to scoff. The majority of the wizards of Wall Street believed then, as they still do today, that earnings are the driver of stock prices and that dividends are only a by-product. Furthermore, intrinsic value has never commanded a big following on Wall Street, where trading and short-term speculation have long been the accepted modus operandis. 

Blaming Wall Street 

But, a closer reading of the book turned Wall Street’s ridicule to scorn. The ways of Wall Street were being blamed, at least partly, for the stock market crash. Williams' thesis stated the following: 
“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?” 

Gradually, particularly among seasoned investment analysts and some academicians, Williams’ valuation theories gained credence. Arnold Bernhard, the founder of “The Value-Line Investment Survey,” perhaps the most famous of all independent, investment research firms, quoted Williams in his 1959 book, The Evaluation of Common Stocks, and echoed his concerns, “Williams postulates that the value of a stock is the sum of all its future dividends discounted by the present interest rates. . . . Because there is no generally accepted standard of value, the market prices of stocks fluctuate far more widely than their true values. The wide fluctuations have in the past imposed a heavy burden on the general economy and undermined the faith of many people in the free market economy. The need, therefore, exists for rational and disciplined standards of value that cannot lead to the wildness of 1929 or 1949 or the present." 

 Next Time: Investing versus Speculating

The True Value of Rising Dividend Stocks

By Greg Donaldson and Mike Hull In recent days, we wrote two blogs that addressed the issues surrounding the sharp fall in stock prices. We were reminded today by a friend and client in New Jersey that we may have missed an opportunity to highlight the true power of Rising Dividend Investing: the sell off has not decreased the income our portfolios produce, neither has it damaged their "true value." As most of you realize, falling or rising stock prices do not affect dividends. Companies set dividend policy on a per share basis, thus the dividends per share our companies were paying a week ago are the same as the ones they are paying today, regardless of the changes in the price of the stock; likewise the income from our bonds and preferred stocks is unchanged. The stocks in our Cornerstone style of management have increased their dividends an average of 17 consecutive years. We fully expect that all 27 companies will increase their dividends in 2007. All of our bonds and preferred stocks are investment grade and most have risen in price since the sell off began. Falling stock prices often cause a flight to safety, and our fixed income securities are considered safe, so they have risen, although not enough to completely offset the sell off in stocks. So from the perspective of our clients' portfolios, what has the sell off meant? We don't think very much. Their portfolios' incomes are the same as a week ago, and we have not adjusted any income growth forecasts. In this regard, our portfolios' "true values" are still rising because we expect dividends to grow and interest rates to remain relatively constant. That being the case, the sell off is like a spell of bad weather -- it may get a lot of headlines, but it isn't going to change our clients lives. Another bit of good news is that the sell off is giving us a chance to nibble on some of our favorite stocks at bargain prices. After all, if a company's "true value" is rising and for some reason its price falls, then, well, you know the rest . . . . Here is the bottom line on Rising Dividend Investing as we practice it: Today's price is not the final arbiter of what a stock is worth. The true value of a stock is a function of the current dividend and future dividend growth, and how these two variables compare to interest rates on riskless securities (US Treasury bonds). These variables exert a kind of "gravitational" pull on the selling price of the stock towards its "true value." Our research shows that the prices of stocks that qualify to be called Rising Dividend Stocks flow back and forth across their "true value" or equilibrium price about every three years. As of Tuesday March 6th, the stocks in our Rising Dividend Models, on average, were nearly 15% undervalued. That means that if our companies continue to pay their current dividends, which we believe is a near 100% certainty, and raise their dividends in line with our estimates, near 10%, that the best estimate we have is that their total return in the coming 12 months should be about 15%. It is not a guarantee, but history shows us few stocks that do not eventually reach their "true value" as long as dividends are secure and growing and interest rates stay relatively tame. That would mean if we do not get our 15% this year, it will be tacked on to next year. In times of high volatility, when the headlines are full of worrisome market news it may seem almost heretical to say that the market sell off is not so much financial news, as news about the weather. But if you have watched the action of Rising Dividend Stocks for as long as we have, you see that it is almost always price that reverts to "true value" not the other way around. If we were judging our investment decisions solely on prices, we would be just as worried as many of the long faces we see on financial television. But we learned a long time ago that today's market action has very little to do with what a stock or the overall market will be selling for a year or two years from now. We believe the best predictor of future performance for Rising Dividend Stocks is, well, you guessed it. Thanks Randy, for the heads up.

Everything Isn't Enron

By Greg Donaldson and Mike Hull

When emotions begin to run high in the stock market and fears seem to spring from the four corners of the earth, it can seem as though common stocks are nothing more than a flickering image on a computer screen. They have no substance, no value-added, no raison d'etre.

The fact that a company has been in business for a hundred years and has weathered every form of natural and man-made disaster, that it has not only survived but has produced a regular and growing profit, paid taxes and passed some of the remaining profit along as a dividend to it shareholders mean very little when traders are fearful and terra incognita surrounds them.

Sell before______happens and its too late. Everything is Enron, nothing is safe, nothing has any substance.

We have been through these kinds of markets and emotions hundreds of times and nothing ever changes. Good stocks, valuable stocks are thrown out as though they were worth nothing more than the stock certificates they were once printed on.

A person sees enough of these kinds of market swoons and you come to the conclusion that they are a natural part of investing. It is a time when the speculators and day traders sell at bargain prices to the long-term investors, who will then sell back to the speculators and day traders two to three years hence -- at much higher prices.

The chart below shows a glimpse of this:

Click to enlarge.













The chart is of the Exchange Traded Fund for the S&P Dividend Aristocrats (symbol SDY). The Aristocrats are a remarkably unique collection of companies that have raised their dividends for at least 25 consecutive years. They also tend to have higher quality ratings than the average company.

The top of the graph shows the price of the SDY. On the bottom is a relative strength chart comparing the movement of the SDY to the S&P 500.

Notice that even though the SDY was rising (top graph) along with the market from June of '06 through January '07, that on a relative performance basis it was trending lower (bottom graph).

In June, when it was clear the Fed had stopped its rate hikes, money moved away from these high quality, dividend payers and went to higher octane stocks. In mid-January '07 these trends reversed, and in the recent market sell off, even though SDY has fallen in price, on a relative basis it has actually risen.

At first this may seem like a hollow victory. The truth is SDY went down; so what if it went down less than the average stock? It means a lot if you take into account that the high-quality companies contained in SDY are now selling on a valuation basis just about where there average stock is.

The market will continue to be choppy for a while longer, but it is clear to us that there are plenty of buyers of high quality dividend-paying stocks. It may not show on an absolute basis, yet, but when the current selling pressure abates, we believe rising dividend stocks will be the new leadership. We believe they are undervalued and better suited to the heightened sense of risk that is in full bloom in the world wide stock markets.

We are not recommending SDF. We are using it as an example because it is a kind of extreme example of what we believe is the best predictor of value -- rising dividends.