Tryanny of Corporate Management

John Bogle, the founder of Vanguard Mutual Funds, emphasizes the point that, over the long term, the return on stocks has equaled corporate dividends plus corporate earnings growth. Later in this essay I quote from his most recent book on the subject. But the point of today's essay to my family is this:

1. Bogle's conclusion regarding the critical role of dividends in the above equation. The earnings growth portion of the equation was, to a large extent, the result of increased prices resulting merely from inflation. It has therefore been dividends that have provided investors with their real (after inflation) return from stocks over the past 100 years.

2. The 4.5% average dividend yield provided by stocks over the past 100 years may be a thing of the past and is not something investors can necessarily count on moving forward.

The reason? Corporations are no longer owned by individuals who actively exercise control over corporate management. Today the vast majority of publicly owned stock is held by mutual funds or large pension funds which do not exercise their voting rights and fail to exercise any control over corporate management. In reality most Boards of Directors today are pawns of corporate management and exercise zero control because there are no longer stock owners who control the Boards themselves. Indeed, it is a small club and Board memberships are filled with CEOs from other corporations.

Contrast that to 1980 when mutual funds and pension funds held less than 10% of publicly issued stock. Back then companies (Boards of Directors and corporate management) answered to real, living, breathing stock owners. But as the number of family owned (or controlled by a small number of individuals) publicly held corporations has dwindled, the result should have been easy to predict. An almost total absence of control over corporate management. The result? A complete plundering of corporate wealth. With no checks or balances, the salaries, bonuses, and retirement packages paid to corporate executives has spiraled out of control. No individual or family controlled public corporation would tolerate even 1/100th (maybe not even 1/1000th) of the hundreds of millions of dollars in individual compensation corporate executives have paid to themselves. Indeed, during the past ten years, 2.7 trillion dollars has been siphoned from corporate dividends of US public companies simply to pay for the stock options given to American corporate managements. This situation is hinted at in a January 7, 2011 article in the Wall Street Journal - The War on Dividend Yields.

It is no coincidence that the dividend yield has fallen so low (below 1.5%). Corporations in America no longer have "owners" and it is no wonder they are being plundered by corporate management. There has been an incredible transfer of wealth away from corporate owners (i.e. today that means holders of stocks via mutual funds and pension funds) to corporate management. So long as such legal theft is allowed to continue, investors can expect to receive far lower returns from their investments since the majority of the dividends that provided the real after inflation return is instead being siphoned off by corporate management.

John Bogle is an outspoken critic of the failures of modern capitalism to address this situation (i.e. the absence of corporate owners in today's society). To get a more complete grasp of the entire situation I encourage you to read Mr. Bogle's 2005 book on the subject, "The Battle for the Soul of Capitalism".

The importance of dividends to the investor, outlined below, is taken directly from pages 322-323 of John Bogle's most recent book, "Don't Count on It":

"… the dividend yield on stocks has accounted for almost one-half of their total long-term return. Of the 9.6 percent nominal total return earned by stocks over the past century, fully 9.5 percent has been contributed by investment return - 4.5 percent by dividend yield and 5 percent from earnings growth. (The remaining 0.1% resulted from an 80% increase in the price-earnings ratio, from 10 at the start of the century to 18 at the end, amortized over the long period. I describe changes in the p/e ratio as speculative return).

When we take inflation into account, the importance of dividend income is magnified even further. During the past century, the average rate of inflation was 3.3 percent per year reducing the nominal 5 percent earnings growth rate to a real growth rate of just 1.7 percent. Thus, the inflation-adjusted return on stocks was not 9.6 percent, but 6.3 percent. In real terms, then, dividend income has accounted for almost 75 percent of the annual investment return on stocks.

... Consider this: An investment of $10,000 in the S&P 500 index at its 1926 inception with all dividends reinvested, would by the end of September 2007 have grown to $33,100,000 (10.4% compounded). If dividends had not been reinvested, the value of that investment would have been $1,200,000 (6.1% compounded) - an amazing gap of $32 million. Over the past 81 years, then, reinvested dividend income accounted for approximately 95 percent of the compounded long-term return earned by the companies in the S&P500."

Investing Versus Speculating

The concept behind a stock investment is the expectation of a return, over the long term, comprised of dividends and increased corporate earnings. It is an investment in the future of a company. As I have indicated in prior posts, there is too much risk involved in selecting companies to invest in - and the only way to eliminate the risk of the selection process is to invest in every corporation (i.e. own them all). In fact, more than an investment in "a company", in actuality this is an investment in the economy of an entire nation (be it the United States via an index fund that owns all publicly traded domestic corporations or internationally through an international index fund).

By definition, over long periods of time, the value of a stock will always equal the dividend + corporate earnings (from 1900-2007 this amounted to an annual 9.5% return based upon a 4.5% dividend and 5.0% increase in corporate earnings).

However, the important "lesson" to be learned here is the distinction between the value of corporate stock over time (i.e. dividend + earnings) versus the short term fluctuations in stock price in the stock market (wall street). The price of any one stock - and the stock market as a whole - varies day by day (indeed minute by minute) and those variations have little, if anything, to do with the intrinsic long term value of the corporate earnings and dividend return. Rather those price fluctuations represent buying and selling by wall street speculators - defined as people who "invest" in stocks not because of the inherent value of dividends and earnings over time, but rather upon the expectation that the price of a particular stock will go up (or down). They are gambling on their expectation that the price will change (up or down) over a set period of time (whether that time frame be one day, week, or two years). The defining common feature is their focus on stock price as opposed to investing in corporate growth (earnings).

I want you to be an investor, not a speculator. Unfortunately the only way to invest in a corporation is through the stock market (i.e. indirectly by investing in a mutual fund which then uses your money to place a purchase of the stocks through the stock market). This is a necessary evil. But do not ever lose sight of the distinction between yourself versus the majority of the people "investing" in stocks. You are not investing in stocks. You are investing in corporate America, and buying stocks to do so. Speculators care only about the stocks and the stock prices. You, on the other hand, are investing in the long term success of corporate America upon the belief that 30-50 years from today the value of corporate America will be far greater than it is today (i.e. that our economy will continue to grow over the long term). The only way to own corporate America is via stocks. But you are not "gambling" on short term price movements of those stocks like the speculator.

Your focus is on one thing - accumulating as many shares of corporate America as you can over a life time. Ignore the current share price on wall street and, if you do look at the share price, be happy when the price is down because that means you are buying at a lower price that you would otherwise pay. But, at the end of the day, the current price really doesn't matter because you are interested in the price some 30-50 years later which will dwarf the prices (highs or lows) you see today.

To My Wife And Children

I've created this blog - and writing this post - for my wife and children with the hope they find (and heed) these words after I'm long dead and gone.

Investing in today's world is very simple - but only if you faithfully follow - without fail - some very simple rules.


RULE ONE:
BUY ONLY INDEX FUNDS AND IGNORE ALL STOCK BROKERS/ADVISORS

I believe in what is known as the "efficient market theory". Simply put, it means that the market is efficiently priced - that all possible information is known and already factored into the current price - and that what the market does tomorrow is unknowable. Therefore although some "experts" may appear to have actually beaten the market in the past, in truth they merely represent expected statistical outlyers - the statistical minority that will be expected to flip "heads" 10 times in a row and thus "appear" to beat the odds.

The biggest single threat to your financial health is believing that "experts" can manage your money for you - that "experts" can recommend stocks or mutual funds to buy or sell. I call these so called experts "Wall Street Predators" because they can only make their living by preying upon financial ignorance. In a "just world" they would be declared illegal and would come with warning labels far more prominent than those forced on the tobacco industry - and trust me - they are every bit as dangerous, if not more, to your financial health as cigarettes are to your bodily health.

Don't be fooled. These so called "experts" do not exist. There will always be individual stocks that will beat the market but nobody can predict which stocks they will be. Likewise there will be individual mutual funds that will also "beat the market" but, once again, nobody can predict which ones they will be. So, principal number one - the one guiding rule that just never be forgotton - the largest danger to your financial health are the Wall Street Predators - stock brokers, stock brokerage firms, insurance companies selling financial products, load mutual funds and actively managed mutual funds, and all sorts of investment advisers - and this includes virtually all of the print and television media - they all want to sell you financial products and financial advice. Turn them off and tune them out. DO NOT use stock brokers. DO NOT buy financial products. DO NOT listen to the financial media whether that be on television or newspaper or magazine.

You invest one way and one way only. You use a mutual fund known as an index fund that holds every single stock in the entire stock market and thus you are investing in the market itself and it is managed by a computer, not by some person who believes he can predict which stock buy and which to sell. And you will use just one mutual fund company - Vanguard Mutual Funds - due to their unique "ownership" structure and devotion to the lowest management fees in the industry.


RULE TWO:
UNDERSTAND ASSET ALLOCATION

The second principle is the importance of asset allocation - in simplest terms the precentage of your money to put in stocks and the percentage to invest in bonds (and cash). The simplest - and perhaps best - approach for most investors is to own two funds - Vanguard Total Stock Market Index and Vanguard Total Bond Index. The investor need only determine the percentage of allocation between stocks and bonds.

The allocation decision, however, is itself a critically important decision. It has been well documented that the allocation decision - the percentage of a total portfolio allocated to stocks and the percentage allocated to bonds, will determine 90% of the portfolio's actual return (and the choice of which funds or stocks to own accounting for a mere 10% of overall return). Thus the stock/bond decision is a crucial one. For this reason, most investors (my wife and children) are probably best served leaving that decision to the experts and investing in just one fund - Vanguard's Target Retirement Fund (the specific fund determined by the target date of retirement). The Vanguard Retirement Fund is a "fund of funds" - it doesn't directly buy stocks or bonds - it merely buys other Vanguard funds (specifically the Total Stock Market Index, Total Bond Index, and Total International Index). The magic is that you leave to the "experts" the decision regarding the percentage allocation decision - which the fund determines by your "target retirement date".

Note that the choice of the word "retirement" is indeed unfortunate and should not be confused with retirement accounts. This fund is perfect for both retirement accounts (such as IRA and 401k accounts), and is equally appropriate for taxable accounts. Indeed, since the idea is that you are having the fund manager this theory of investment only really works if the investor makes this the only investment of his/her entire portfolio because the allocation decisions of the fund are made with the presumption that the stock/bond allocation is being applied to all of the investor's assets. Alas, most of us are unable to allocate all of our assets into one Vanguard fund because we don't control where our money is being invested.

An alternative is to own Vanguard's Target Retirement Fund and check it's allocation quarterly/annually and mirror that allocation in the rest of the portfolio. At this point in time I track Vanguard's Target Retirement Fund 2020 allocations as a guide to my own allocation decisions.

My Recommended Reading

The books I want my wife and daughters to read:

Gregory Baer & Gary Gensler, "The Great Mutual Fund Trap" (2002)

John C. Bogle, "The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns" (2007)

John C. Bogle, "John Bogle on Investing : The First 50 Years" (2001)

Burton G. Malkiel, “A Random Walk Down Wall Street”

William J. Bernstein, “Four Pillars of Investing: Lessons for Building a Winning Portfolio”

Larry E. Swedroe, “The Only Guide to a Winning Investment Strategy You’ll Ever Need”

Ed Slott, “The Retirement Savings Time Bomb and How to Defuse It”