Thursday, April 24, 2014

The Dividend Theories of John Burr Williams, Part II: Investing versus Speculating

This is the second blog in a series exploring the theories of John Burr Williams. You can read the first post here.

John Burr Williams’ book, The Theory of Investment Value, was not about beating the market or getting rich in the market.  It was really a wake-up call to the investment elite to offer them a theory of investment value that would encourage more long-term investing and less speculation.  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 it was clear by their decisions 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’ 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).”

As an affirmation of Williams’ theories about intrinsic value and speculation, let’s look at the Great Recession of 2008-2009. From peak to trough, both price and earnings of the Dow Jones Industrial Average fell by just over 50%, while dividends fell by only about 15%.

John Burr Williams would point to the relative minor dividend cuts as the reality of what should have happened in the stock price pull back. In essence, many investors were looking at either earnings or prices as the indicator of value, which turned out to be dead wrong.

If corporate America believed that things were as bad as many speculators did, they would have cut dividends more in line with the 50%+ fall in earnings. That did not happen, and the massive sell-off provided one of the best buying opportunities in our lifetimes. Investors who focused on dividends rather than earnings and prices were able to profit from it.

Williams extolled the virtues of a long-term view of the investment markets.  He believed profitable investing could best be assured by focusing on the long-term growth rate of dividends.  How right he was.  Since 1960, the annual price growth of the Dow Jones Industrials has averaged about 5.9%.  That figure is remarkably similar to the average annual growth rate of dividends of near 5.6%.  While these growth rates are very similar, they do not move in a “tit for tat” manner.  Dividend growth over the years has been fairly consistent, while stock price growth has been very volatile.  But, on average, every two to three years they converge.

Market volatility is frightening for many, but long-term dividend investors should celebrate it.  Large discrepancies between prices and dividends represent clear buying or selling signals.  As John Burr Williams predicted in 1938 and a half a century of evidence shows, prices and dividends always converge. Long-term investors who focus on the dividend are not only able to avoid market irrationality, but profit from it.

Next time in a blog entitled, “Chickens for Their Eggs,” we will share why John Burr Williams believed that dividends alone should be the guide to intrinsic value.