Efficient Frontier
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William J. Bernstein

How Much Pie Can You Buy?

During particularly bad days at the office, I have a recurring fantasy: Thomas Friedman, columnist for the New York Times, calls me up and says, "Bill, the world has my head spinning. I just can’t keep the players straight any more—I’m shutting down my word processor and going fly fishing for a few years. Care to fill in?"

You see, Tommy’s no ordinary scribbler. He’s the "correspondent-at-large" for the Gray Lady. He gets to talk to anyone he wants and write about whatever strikes his fancy. Of course, I’m flattered—that’s the sweet thing about this daydream—but I have to demur; I just can’t turn the kind of stuff he does. Here’s one of my favorites, from an essay dated October 17, 1999, shortly before the market peaked out:

The Dow Jones Industrial Average dropped 1,266 points today after Amazon.com announced that it had inadvertently made a profit…

The main point of the article (preserved for posterity by a brave soul untroubled by the long arm of the Times legal department) was that in late 1999, it was no big deal that Amazon’s pie-in-the-sky earnings prospects supported a sky-high price. But when Amazon finally developed real earnings—that is, when pie-in-the-sky became "pie-on-the-ground"—the company as well as the entire market suddenly became a lot less appealing. Or, as one of Tommy’s mythical analysts put it:

"I swear, I thought Bezos' actual plan was to skip making a profit and go directly from being an I.P.O. to being an N.G.O. for distributing books cheaply," said another analyst. "I don't know what Amazon's future is as a company—but as a charity, wow! What a write-off machine! It could have been called "Unicef.com." Really, who's given away more kids' books at cost than Amazon?

Almost on cue, the heavens turned into one enormous Friedmanian celestial pastry shelf. Its two main supporting brackets were technologically-driven acceleration of earnings growth and share buybacks. The trouble was, these two props weren’t just weak; they simply didn’t exist at all.


In the Beginning . . .

There is Gross Domestic Product. Over the long haul, this is the engine of corporate profits and thus of stock prices. Below, using data from Angus Maddison’s wonderful "The World Economy: A Millennial Perspective," I’ve plotted the real GDP of the two winners of the global sweepstakes since 1820:

I’ve laid these data out on a semilog scale to depict the growth rates; since 1820, they were 3.66% and 1.97%, for the U.S. and U.K. respectively. (By the way, this pinpoints the eclipse of the British Empire a bit earlier than conventional historical analysis.) Most of the difference between the two nations can be ascribed to the fact that our population grew faster than Britain’s—1.87% per year versus 0.58% per year. On a per-capita basis, the annualized rates of GDP growth are much closer—1.75% versus 1.38%.

Step back and take a long look at the above graph. Anyone detecting a rapid acceleration of GDP growth in either nation during the past few decades should report immediately to his optometrist.


The Next Step: Total Corporate Profits

The next piece of the puzzle is supplied by the Bureau of Economic Analysis, the government’s premier source of macro data. Switching gears ever so slightly, we’ll use nominal (current) dollars from 1929 to 2000 to see how total corporate profits track GDP. The overall nominal growth rates for the seven decades are 6.63% and 6.41% respectively. (If you want to adjust to real GDP/profits, just subtract out the compounded 3.3% rate of inflation for the period plotted.)

Notice how smoothly corporate profits track GDP. To underscore this relationship, I’ve plotted the ratio of corporate profits to GDP:

Since the turmoil of the Great Depression, when earnings disappeared completely for two years, corporate profits have remained fairly constant at about 10% of GDP. This ratio is not without political and sociological importance; many on the political left have decried the portion of national income flowing to the corporate sector. The above plot negates this argument; this is no small blessing for the body politic.

Let’s summarize what we’ve learned so far:


How The Pie Is Sliced

So, the pie gets about 3.5% bigger each year, adjusted for inflation. The problem, of course, is that the slicing gets done far, far from your purview. One of the underpinnings of the 1990s buy-now-and-hold-your-stocks-forever happy talk went something like this: "Forget dividends. Corporations make much better use of their earnings buying back shares. This is a blessing for shareholders, since buybacks result in unrealized, thus untaxed, capital gains."

Let’s look at the numbers. (We're still using nominal data.) Melding Bob Shiller’s data with that of the Bureau of Economic Analysis, we see from 1929 to 2000, GDP rose by an annual nominal 6.63%, corporate profits by 6.42%, and per share profits by… drum roll, please… 4.98%. Wait a cotton-picking minute! This means that per share earnings—what you and I actually own—grew about 1.5% per year less than GDP and aggregate earnings! This can’t be right! It implies, of course, that those nasty investment bankers have been watering down our shares at a 1.5 % rate. Well, I’m shocked, truly shocked.

Things were a bit different in the 1990s, bolstering the case for the paradigmistas: the numbers for 1990 to 2000 were 5.46%, 7.93%, and 9.06% respectively, suggesting that about 1% per year was being added to stock returns from buybacks during that period. But there’s a reliability problem measuring earnings growth over such short periods, since over time spans of less than a few decades, things become very sensitive to starting and ending points. For example, begin the calculations in 1980, and the numbers change to 6.51%, 7.71%, and 6.35%. Goodbye buyback bonus.

I’ve summarized these nominal data below:


GDP Growth

Growth of Total Corporate Profits

Growth of Per-Share Corporate Profits













The rosiest data—from 1990 to 2000—suggest that there is about a 1% kicker to equity returns from buybacks, whereas the longer-term data suggest a 1.5% shortfall. An underlying principle of finance is to rely always on the longest time series; I have greater faith in the 1929 to 2000 numbers than on those from the last decade.

Some additional perspective is garnered in a piece by J. Nellie Liang and Steven A. Sharpe from the Federal Reserve Board Washington, D.C. They observed that from 1994 to 1998, corporations repurchased an average of 1.91% of outstanding shares per year. Unfortunately, this was offset by 0.87% of stock issued for options granted to employees, netting out to an overall repurchase of 1.04%, almost exactly what we calculated from the above (independently derived) data. Since employees were paying a portion of the market price for their options, the option grants were not a total loss for the companies. But the authors' key point was this: with earnings yields of only 3% (a PE of 30), the companies were paying an average of 29% of their earnings for buybacks in addition to an average 37% dividend payout.

The math here is pretty simple: add the 29% earnings buyback cost to the 37% dividend payout, and you have 34% of earnings remaining—about 1% of market cap—available for reinvestment. This is not tenable in the long term. Historically, U.S. corporations have sold at an earnings yield of about 7% (that is, a PE of 14) with dividend payouts of about 55%, meaning that they reinvested about 3% ([1- 0.55] x .07) of their market value each year. With only 1% reinvestment, the capital has to come from somewhere else.

The key issue, then, is the amount of "leakage" from long-term GDP growth to per-share earnings caused by net new stock issuance. Burton Malkiel, for example, in the latest edition of A Random Walk Down Wall Street, estimates per-share corporate earnings to grow at a 6.5% nominal rate. Combining this with 1.5% dividends and a liberal dose of "Please God, don’t let multiples collapse from here," he arrives at an expected stock return of 8%. But as we can see, his estimated 6.5% per-share earnings growth rate sits between a rock and a hard place: corporations either have to commit funds to buybacks that in previous years had fueled earnings growth, or they revert to old habits and allow 1.5% of GDP growth (which, as we saw above, over the long haul averages 6.6%/3.3% nominal/real) to leak out, yielding the historical 5%/2% nominal/real per-share earnings growth rate. (By the way, no one can consider themselves a serious investor unless they read each new edition of Random Walk when it comes off the press. The seventh, written in 1998, is now available in inexpensive paperback.)

In the long term, obviously, corporate capital needs will not be met by the 1% of market cap left after paying for buybacks and dividends; it must of necessity come from debt and new share issuance, either as primary or secondary offerings. It made no sense, of course, for corporations to be net buyers of their own shares in the expensive 1990s to an even greater extent than they were in the cheaper previous decades. In the aggregate, one hopes that corporate treasurers are not stupid; when the ducks quack, they generally haul out the feed bag. In the end, long-term shareholders get neither pie-in-the-sky nor pie-on-the-ground. They get a steady stream of increasing earnings and dividends, diluted with a liberal amount of bread crumbs, courtesy of the investment bankers.

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