The Age of Jordan

Mark January 16, 2003 down in your calendar as a date to remember. I believe this day in history will prove to be a pivotal turning point for investors – a day of true reckoning.

At 4:48 P.M. on Thursday afternoon, Microsoft announced its first-ever dividend. I smiled when I read the announcement. I knew this was big. But not for the reasons you might expect.

Sure, Microsoft’s stock has been in trouble for three years. After reaching a high of $119.13 on Dec. 27, 1999, it has tumbled down to just over $55 a share. The company had to do something to make its stock seem attractive to new investors.

So it decided to pay its shareholders a measly 16-cent annual dividend (8 cents once the 2-1 stock split takes place on Feb. 14). That’s a 0.31% yield – well below the S&P 500 average of just 1.7%. This is hardly the way to bolster a $55 stock back up to $75, let alone $100. And it’s certainly nothing to get overly excited about – or at least it would appear that way to most investors.

But most investors weren’t able to recognize that Microsoft was a highflier in the 1980s. And I doubt most will recognize the importance of its Jan. 16th announcement.

Microsoft Dividend: Getting Old

By issuing a dividend, Microsoft admitted it was getting old. It silently acknowledged it could no longer perform at the same level it did back in the early 1990s. It was like watching an aging Michael Jordan play for the Washington Wizards.

In his prime, there was no better player than Jordan. He could take a game over single-handedly. He could beat you off the dribble. He had a deadly fade-away jumper, an explosive move to the basket and killer instincts – that helped him rack up six NBA titles in the 1990s.

What’s more, in his prime, Jordan never seemed to labor on the court. He had the stamina of a marathon runner and the grace of a dancer. He was a winner.

Throughout the late 1980s and all of the 1990s, Microsoft was the Michael Jordan of the investment world. Its stock made investors filthy rich. Microsoft was the epitome of all growth stocks. With a return on equity above 20%, there was no need for Microsoft to worry about dividends in the ’90s. The company was reinvesting its profits in its business. And who could argue with the results?

But it’s not 1992 anymore. Both Jordan and Microsoft are older. And both have had to change the wining formula that made them great.

Jordan can no longer rely on his athleticism to overwhelm his opponents. Instead, he has to outsmart the younger, stronger generation of NBA players. And that doesn’t always work. Unfortunately, being smarter than your opponent doesn’t put points on the board.

Microsoft Dividend: Not What It Used to Be

Likewise, Microsoft isn’t the growth company it was 15 years ago. It isn’t attracting shareholder dollars like it did in 1990, or even 1995. And it isn’t investing in itself the way it did in its prime. That’s why it is offering a dividend now. Microsoft is desperate to stay competitive in this tough market.

I don’t think either Jordan or Microsoft have much left in them.

But that’s life. Yesterday’s legends are eventually replaced by the day’s up-and-coming stars. But does that mean you have to lament the passing of an era?

No. You can look at Microsoft as a mature company – and evaluate its promise to pay a dividend for what it’s worth. Do you want income stocks in your portfolio? Then the world’s dominant producer of operating systems might be right for you.

On the other hand, if, like a new player making his way to the big leagues, you’re still in the market for capital gains, you can look at Microsoft’s history for a little instruction. How so?

One way is to look at which companies are investing in themselves the way Microsoft did back in the late ’80s and early ’90s. In 1992, Microsoft invested $767 million in its own property, plant and equipment (PP&E). To put that in perspective, the software giant only brought in $708 million in total net income for the year. Its PP&E to net income ratio was a robust 1.08.

As a capital-gain investor, you want to own equity in a company when it is in the growth stage. And a company can only grow when it invests money in its business. That’s why the PP&E number is an important one.

Microsoft Dividend: Microsoft’s PP&E Ratio

For fiscal year 2002, Microsoft’s PP&E to net income ratio was 0.2. The bottom line is Microsoft isn’t investing the same amount of money, relative to the size of its business, that it was in the ’90s. Why should you pay full price for a company that is growing at a fraction of the rate it was just 10 years ago?

The answer is, you shouldn’t. And don’t let anyone fool you into believing that a 0.3% dividend yield will make up for a lack of capital investment spending. It won’t.

The next wave of highfliers are investing in their own businesses right now. They are building plants, buying new equipment and setting the stage for expansion. And I’m willing to bet you won’t find any of these small, up-start companies offering a dividend. Instead, their earnings will be used to invest in their businesses.

If you really want to make a lot of money in the next five, ten, or even fifteen years, look for the smaller companies (trading on the major exchanges for under $10) that have rising sales, net incomes and PP&E.

These are your tickets to great profits. And trust me, when the bottom finally sets in and the next bull market comes around, I can guarantee you Microsoft won’t be leading the way. The next wave of highfliers are no-name, small-cap stocks…busy investing in themselves…just like Microsoft did in 1986.

Best regards,

James Boric
for The Daily Reckoning
January 23, 2003

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Bloomberg reports that pension fund assets fell 10% in the 12 months up to Sept 30, 2002. The 1,000 funds Bloomberg reviewed lost about half a trillion dollars. Over the last 2 years, they’re down about twice as much – or about $1 trillion.

That’s a trillion that will have to be made up somehow…or a trillion less retirees will have to spend.

A trillion here…a trillion there. If that were all there was to it, we’d pay it no mind. But along comes our own Eric Fry, quoted by Alan Abelson in this week’s Barron’s with more gloom and doom.

Eric noticed a $5.5 billion hole in the pension accounts of Deere & Co. The hole was camouflaged by an accounting ledgerdemain that has become common among major companies. As Eric explained to Barron’s, much of the money was called “other post-employment benefit obligations” rather than “plain-vanilla pension obligations”.

“If you used the same accounting for the operations side that is used on pension funds, you would be put in jail,” Abelson quotes Ethan Era, chief actuary with Mercer HR Consulting.

If that weren’t enough, most large pension funds are still using absurd assumptions to calculate how much money they need. IBM, to use an example cited by Abelson, recently reduced its expected rate of return on pension assets from 9.5% to 8.5%. Based on the returns from the last three years, IBM should have put a minus sign before the last figure.

Before it is all over – that is, before the end of this slump – people will probably go to jail for accounting fraud. But not before the poor lumpeninvestoriat have lost a lot of money.

These pension losses and hidden costs will take a lot of juice out of the U.S. economy in the next few years. Companies will have to sock away much more than expected to meet their pension obligations. The money will have to come from somewhere. Meanwhile, the boomers are thinking about retirement. As they give up on stocks, they’re going to have to increase savings in a major way. Already, the savings rate rose 50% in 2002…from 2.3% of disposable income in January to 3.5% in November. Each percentage point equals about $70 billion.

A rise in the savings rate to 6% would take about $200 billion out of the consumer economy, probably pushing the U.S. into recession.

In the long run, this is good news. The U.S. economy needs real savings. But in the short run – which could be for the next 10 years – it is disastrous. Savings take money out of the consumer economy…thus depressing sales, employment, and profits.

Hey…I think we’re turning Japanese…I think we’re turning Japanese…I really think so…

Konnichiwa…(hello in Japanese) Eric,

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Eric Fry, reporting from New York…

– Now you see it, now you don’t. We are referring of course to the stock market’s splendid New Year’s rally. After the first three trading days of 2003, the Dow had racked up a sparkling 5% gain. But yesterday’s losses snuffed out all that remained of that early January advance. The Nasdaq slipped only 4 points yesterday to 1,359. But the Dow slumped 124 points to 8,318 – dropping the blue-chip index into the red for 2003.

– So just like that, another bear-market rally bites the dust. This kind of dispiriting trading action can be pretty rough on the lumpeninvestoriat. Wall Street’s finest had assured them – and reassured them – that stocks could not possibly fall for four straight years. But sadly, it looks like stocks can indeed fall for four straight years…maybe even five or six. The die is not yet cast for 2003, of course. Stocks may recover and validate the optimism of Wall Street’s strategists. Then again, the market may continue falling, thereby solidifying the strategists’ reputations for moronic and misguided forecasts.

– We don’t know what will happen any more – or any less – than the strategists. So we merely retreat to the simplistic notion that bad things tend to happen to investors who buy richly valued stocks, and good things tend to happen to investors who bide their time, waiting to buy inexpensively valued stocks. This sort of “tactical ignorance” causes us to draw near to gold like a suckling pig to a sow’s teat. What else is a suckling to do? Gold, like the sow’s milk, is reliable sustenance, at least…An investor could do worse.

– Yesterday, gold proved itself to be quite nourishing indeed. The precious metal brushed up against the $360-mark by gaining $2.40 to $359.90 an ounce. The XAU Index of gold stocks jumped two and a half percent to 77.7.

– When President Bush first announced his new “stimulus plan,” we considered it no worse than any of the other tax- and-spend proposals that the knuckleheads in Washington dream up from time to time. But we now suspect it is a horrible idea. The reason: 110 economists think it’s a terrific ides. The Washington Times reports: “A letter signed by 110 economists, including three Nobel Prize winners, urges Congress to support the main elements of President Bush’s $647 billion tax-cut plan.” Can any idea that’s applauded by 110 economists NOT be a bad idea?

– The President’s big-time spending plan is but one of may deficit-spending proposals being cooked up by politicians from Bombay to Bonn. Deficit-spending is the hottest global macroeconomic craze. Not only is the U.S. hurtling toward a $300 billion deficit in 2003, Germany and France are also running big deficits. Both countries are violating the European Union’s limits on budget deficits – 3% of GDP.

– The deficit-spending craze is one of many reasons why James Grant matter-of-factly asserts, “The fixed-rate obligations of the United States government, and investment-grade corporate bonds, are for losers. It’s a canard that the creditor class rules these United States. Debtors rule…Creditors willingly sacrifice the prospect of capital gains for security, a security that, often as not, is illusory. They are the saps of the world…Creditors have possibly less political standing than smokers in millennial America.”

– Grant continues: “Record-high ratios of indebtedness to GDP, record ratios of slow loans to loans outstanding, and 1.5 million bankruptcies in the latest 12 months all point to the same conclusion: the United States economy must reduce its leverage, sacrificing top-line economic growth in the process.”

– “Debt repayment could be the dominant force in the economy, not only for 2003, but also for the next several years,” bond fund manager Van R. Hoisington tells Grant. “This deleveraging will result in the stagnation of capital spending and moderating inflation, causing interest rates to fall.”

– The New York-based editor of the Daily Reckoning is not persuaded that long-term interest rates will be dropping substantially from current levels. But he has little doubt that “deleveraging” by American corporations and consumers will put a crimp in the sorts of consumption and capital spending that drive our economy. American corporations and consumers are both becoming a lot more eager to repay their old debts than they are to rack up new ones.

– Given these trends, will the President’s stimulus plan do any stimulating? We are dubious.

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Back in Paris…

*** An ABC/MONEY poll shows consumer confidence falling. Only 24% of those polled think the economy is in good shape. The drop in confidence was the sharpest in 2 decades.

*** 30-year bonds are near their highs. The bond market, too, seems to think the economy is sinking.

*** But home construction is running at a 16-year high. Go figure.

*** In the popular mind, Wall Street is an industry that helps investors make money. It is nothing of the sort – it is an industry like any other; it makes money for itself by selling things at a profit. What does it sell: the HOPE of making money.

That’s why analysts typically recommend 49 ‘buys’ for every single ‘sell’. It’s also why Wall Street strategists almost always expect stock prices to go up – how could they make any money if investors thought stocks would go down?

Suppose that the Wall Street crowd really did have an investment that would produce above-market profits. Would the Masters of the Universe offer it to their lumpeninvestoriat customers? Or hold it for themselves? Wall Street professionals have access to all the capital they want. Why would they ever fail to take up an extraordinary investment? It follows that the investments Wall Street sells are the ones it doesn’t want for itself, which is true of every seller.

People who buy from the financial industry think that they are not consumers of Wall Street’s products, but investors. They imagine themselves as mini-Warren Buffets or Carl Icahns. But they don’t think like either of them. Both Buffett and Icahn buy businesses, not stock – often by- passing Wall Street altogether. They think like business buyers – analyzing the real assets and real profitability of the enterprise in order to figure out how they can make money with it. The typical stock-buyer, by contrast, hasn’t a clue. He’s just hoping the stock will go up…because he heard someone on CNBC say it would.

Happily, they all get what’s coming to them – Buffett, Icahn, Mom & Pop. What a wonderful world we live in, dear reader.

[Editor’s note: If you’ve sent an e-mail to us in the past couple of weeks and we haven’t responded…don’t despair! We always like to here from you; in fact, it’s one of the more pleasing aspects of our work. But as many of you know, we’re working on a book to be published by Wiley & Sons, and the deadline draws near. We simply haven’t had time to respond. Thanks for your understanding. Back on the job soon!

À bientôt,

Addison Wiggin,
The Daily Reckoning