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.

When China Sneezes . . . The US Doesn't Have to

As I write this, the Dow Jones is down about 400 points or just over 3%. The fall in US stocks is a carry over of the selling that occurred in China and the Far East overnight. Stocks in China fell by almost 10%, as investors sought to lock in profits in the face of a rumored Chinese crackdown on speculative buying and stock manipulation. The Shanghai domestic stock market has been nothing short of phenomenal, recently, racking up a gain in 2006 of 127% and 13% year to date. To say the Chinese market may have been a bit overbought, is an understatement of monumental proportions. But what does a sell off in the frothy markets in China have to do with the rest of Asia, Europe, and the US, where stocks have also sold off sharply? The answer is the interrelatedness of the world wide capital markets and economy. Welcome to the global economy. If any of the world's major economic players sneezes, there is the chance that the rest of the world may catch a cold. If you think of this in reverse, it may be more understandable. If the US would have reported an Enron like scandal yesterday that caused US stocks to fall sharply, today all the major stock markets around the world would be down in sympathy with us. We are so important to the world's economy that any disturbance in our economic prospects or confidence impacts everyone, because we are the largest consuming nation in the world. How about China? How important is it in the world's economic scheme of things. On an exchange adjusted basis, China is about one sixth the size of the US, and represents about one thirtieth of World Gross Production. Trouble in such a small portion of the world's economy would not seem to justify such a violent reaction to stock markets in the world's economic capitols. Indeed, we see few fundamental reasons for the world wide stock sell off, and we do not believe that economic growth estimates will change much as a result of today's sell off. Stocks sold off, mainly, because of the ease of selling. All you have to do is to turn go on your Internet and sell until your fingers wear out. In our judgment, in the days and weeks ahead today's selloff will be seen for what it is: a trading event and not a fundamental economic event. The fundamentals are still strong and stock prices will, ultimately, follow the fundamentals. How about the prospects that the US stocks markets, which had a good year in 2006, could be overvalued? There is good news on that front. US stocks did rise over 15% in 2006, but they are now selling at about the same PE and dividend yield than did at the beginning of 2006. The price rise in 2006 was entirely justified by the growth of earnings and dividends. US corporate earnings were better than expected in all four quarters of the year just past. The US economy is growing near 3%, and the Fed has stopped raising rates. If the economy were to slow for any reason, the Fed would quickly cut rates to spur economic growth. Finally, my friend Dr. Spear sent me an email and said, "Is this 1929 or 1987?" The answer, Doc, is neither. In 1929, on Black Monday, stocks fell by almost 13%. That would be equivalent today of nearly 1650 points. On Oct. 19, 1987, stocks fell by an amazing 22.6%, equivalent to nearly 2850 points today. The US markets have experienced numerous 3%-5% selloffs in its history. Few have led to any serious economic downturns. We are confident this one will not either. With US stocks having recently reached all time highs, some profit taking was probably inevitable sooner or later. The sell offs in Asia and Europe last night were just a good excuse for it to happen today here. While we believe the volatile markets will calm down in the days ahead, we expect that some additional selling may occur in the near term. We have put together a buy list of terrific companies that we would like to own, we hope we get the chance to do some nibbling. China may have sneezed. They might even have a cold, but our economic strength will help us ward off any cold bug, and, indeed, help pull them out of their chill. We'll keep you posted on any changes in our thinking.

Airbus Cries Uncle, Boeing Tightens the Noose

The news this weekend from Europe is that Airbus, the European quasi-public aerospace company, and Boeing's biggest competitor, has delayed the announcement of its planned restructuring. The reason: France and Germany, the two main governments behind the project, are battling over how many layoffs they must absorb in their respective countries. Reuters reports the following: In a sign of renewed tensions within EADS, French co-CEO Louis Gallois -- who also heads Airbus -- defended his restructuring plan in a separate statement issued by the Toulouse, France-based aircraft maker. "I made proposals which I deem balanced, both from an industrial and a technological point of view, and which serve our objective of economic competitiveness," Gallois said. "Airbus cannot delay any longer implementing Power8," he said. France's two main financial newspapers, Les Echos and La Tribune, reported Monday that Gallois is seeking to cut close to 10,000 of the company's 55,000 jobs, sell off some production units and centralize assembly of the A350 in France, in exchange for agreeing to build a future revamp of the single-aisle A320 airliner in Germany. Under the plan, France and Germany would each contribute between 3,000 and 4,000 of the job cuts, Les Echos said. Neither paper named sources. Airbus and EADS both declined to comment on the restructuring proposals or the discussions. You will recall recently I discussed the very favorable position in which Boeing's new CEO, Jim McNerney finds himself. He has new aircraft that the airlines want, and he is on schedule to deliver them. McNerney has the manageable problem of motivating all of the "princes" at Boeing to subjugate their interests for the good of the company's competitive battle against the "kings" at Airbus. This weekend, France and Germany, two of the "kings" are at odds over who has to absorb the most layoffs and who gets to build the new airplane. Two CEOs, three countries, countless unions, overdue planes, and Airbus' blood is in the water. There are plenty of "kings" but no captain. Jim McNerney left a great job at MMM to take a job that nobody has done well for a decade at Boeing. Many wondered why; now we know. Airbus is very close to Airbust. Of course the Franco-German consortium will bail out Airbus but at a terrible cost to their competitive position. If Boeing can stay humble, the remainder of the first decade of the 21st century will be theirs. If they can stay hungry, perhaps they will own the second decade outright. We own BA in our Capital Builder investment style. Please review our conditions for using this site.

Gentle Ben is Not a Bear, He's a Bull

Fed Chairman, Ben Bernanke, gave the first leg of his semi-annual report to the Congress on the condition of the economy today. As he began reading his prepared text, he knew what would soon be happening in the capital markets. He knew his "not too hot, not too cool" comments about the economy would rally both stocks and bonds.

But of equal importance was that he also knew that almost all of the world's stock markets were near multi-year highs. Thus, a speech emphasizing a balanced view of the economy would likely send stocks to new highs and give momentum to the world-wide bull market, while a more cautious tone would likely cause a sell off in stocks and keep animal spirits in check.

Ben was gentle, and he turned the bulls loose.

The charts below show the S&P 500 Index, which represents about 85% of US market capitalization and the EAFE Index, which measures the majority of the rest of the world's market cap. These two charts show that US and world-wide stocks have been in a solid uptrend since June. Both charts also show that US and international markets have been biding their time over the last month, digesting earnings and waiting for Mr. Bernanke to speak. Finally, both charts show a break to new multi-year highs today after Mr. Bernanke spoke.

None of us can see the future, but this much we can know. Mr. Bernanke knew what he was doing when he took a balanced tone, and he knew what would happen. We can only conclude that he believes that the soft-landing we have all been hoping for is playing out.


Please click to enlarge the images.

Boeing is Still Cheap

In recent days Boeing has popped higher on news of new orders for planes and continued delays on the Airbus A380 jumbo jet. I think the good news is likely to continue at Boeing as much for the troubles at Airbus as for BA's new CEO, James McNerney. McNerney has a pedigree that is hard to match, having had stints at P&G, GE, MMM, and now Boeing. If he lives long enough, he may be the first person in history to manage all 30 of the companies in the Dow Jones Industrial Average. In this case, however, it is not his impressive pedigree that portends continued success at BA but his unique success at MMM. When McNerney joined MMM, it was a wonderfully innovative company that many investors had soured on because the company had a history of discovering great products that either fizzled or were copied by other companies that could produce and market the products more profitably. MMM had many wonderful innovations slip through their fingers because their product list was so long and ever increasing, and they never got around to betting and backing the right horses in their stable. At MMM, McNerney built consensus around the idea of "commercialized innovation." In some ways, it was really very simple. He sold the employees on narrowing their focus to a smaller list of innovative products that had sustainable profit potential and barriers to entry. In addition, he reduced redundant layers of management and put a quantitative tracking system in place that measured all the bets. Wall Street applauded his initiatives and the stock moved higher. Boeing is a tougher nut to manage than MMM because of its huge capital commitments and the winner-take-all nature of the commercial and military aerospace industries. Additionally,Airbus, its only other viable competitor, has the backing of the governments of Germany, France, and Spain. BA has won many contracts and made deals at the four corners of the earth, but they have not consistently given back much to their investors. Indeed, operating earnings for 2005 were about the same as they were in 1991. I think McNerney is the right person for one of the most important jobs in the world, because he is a consensus builder, and he knows how to allocate capital, having learned this from the master, Jack Welsh, while at GE . I believe McNerney will lead BA much the same as he did MMM, by consensus and focus. There are too many layers of management at BA, but what's worse is that there are too many "princes" who believe that their view should be the company's view. No company stands to gain more from the global economy than does BA, but it cannot continue as many little companies within a company. I believe McNerney can convince most of the"princes" that their kingdoms will prosper if the stock price continues to go higher, and the stock price will go higher if the company is able to do a better of job of allocating its capital and has a better focus on the bottom line. Those princes he is not able to convince will probably be looking for employment elsewhere very fast. If you want a powerful way to think about Boeing it is this: Boeing has what amounts to a toll road across every continent and ocean in the world. I am not completely ignoring Airbus. It is a strong company, but a focused, disciplined strategy by Boeing will be nearly impossible for Airbus to compete with. It has two CEOs, it is sponsored by three European governments, and is a subsidiary of another publically traded company, EADS. Where Boeing has princes, Airbus has kings. In this regard, I think the better bet is against the kings, espescially with Jim McNerny on our side. I think the stock may be 15% undervalued. We own BA in our Capital Builder style of management. Please see terms and conditions of this website on the sidebar at the right.