Letters from our readers.
March 26 1999 3:30 AM

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In "Crapshoot," Bruce Gottlieb, like Clive Crook before him, thinks he has found a flaw in our argument that stocks are undervalued. He has not. In a Slate "Dialogue" last year, Crook claimed that we were contending that the value of a company is the present value of its stream of future earnings and that such a contention was false. Gottlieb's piece, in an easy-to-follow way, demonstrates Crook's argument that, if you value a firm by discounting its earnings, and all earnings are not paid out in dividends, then you are double-counting.

But the problem with what Crook and Gottlieb are saying is that we never based our theory on earnings but instead, as we wrote in our Wall Street Journal piece on March 17, 1999, on the "money a stock will put in your pockets through the profits generated by the company that issued it." Neither in this year's piece nor in our March 30, 1998, Journal piece did we claim that all those profits--or earnings--would go into your pockets. What we said explicitly was that the proper figure to use to measure the cash generated by a company was somewhere between the lower bound of the dividend that a firm pays and the upper bound of its official after-tax earnings. Indeed, in our first piece we explicitly highlighted the fact that earnings are a problematic measure of cash flow because of the potential that a firm might grow simply through retentions.

But Crook and Gottlieb are intelligent, well-intentioned journalists. What led them astray? They both cite an argument against our first piece raised by Jeremy Siegel of the Wharton School. He claimed that it is a "mistake" to assume that dividends per share will post real growth, as we did in our calculations, because dividends, in theory, should only just keep up with inflation.

Crook and Gottlieb appear to have been convinced that real earnings growth only reflects retentions and that real dividend growth must be zero. While Siegel's point fits the simplest introductory economic models, it is contradicted by the facts: Historical data on dividends reveal significant real growth of dividends per share. For example, in the latest edition of Siegel's excellent book Stocks for the Long Run, Table 5-1 on Page 79 shows that the growth of real dividends per share has been 2.1 percent on average since 1946 and positive since the 19th century. (In our calculations, we assume 2.1 percent real growth in dividends.)


What Siegel, Crook, and Gottlieb say can't happen--dividends growing faster than inflation--has been going on for almost 130 years. Where has all this growth come from? We treat that question at length in our book, relating the observation to theories at the frontier of the branch of economics known as "Industrial Organization," but here is a hint: The simplest textbook model of the perfectly competitive firm doesn't do a great job of describing the companies that have driven the market higher and higher.

Discounting dividends is uncontroversial, and the fact that they grow is clear. It is interesting that Gottlieb says that, on the strength of dividends alone, the Dow should be about 14,000 using our theory. That is a good start. Even sticking with dividends alone, the number is pushed considerably higher than that if one accounts for repurchases and the tax advantage associated with them. So much for the crazy stock market bubble. Dow 14,000 is clearly a lower-bound estimate. Today, many enormous firms don't pay dividends at all. These firms have value because, ultimately, they will deliver cash to their shareholders.

Crook and Gottlieb think that all valuation techniques are out the window for firms that don't pay dividends, but they are misinformed. There is a very large peer-reviewed academic literature on this topic. The basic idea is simple: You can base a value measure on earnings instead of dividends if you can identify those things that you are double-counting and make sure that you only count them once. For example, earnings themselves are a reasonable measure of the dividend that you use to construct the value of the firm if all earnings are paid out each year. Such an example is no pipe dream. Real Estate Investment Trusts, for example, pay out 95 percent of their earnings, and many of them post earnings growth well above inflation year after year. In 1999 alone, REITs, on average, are expected to increase their earnings by 10 percent, with inflation at about 2 percent. When firms retain lots of earnings it gets more complicated, with the growth of earnings increasing as more and more cash is retained in the firm. For those who can't wait until the fall release date of our book Dow 36,000 and want to start thinking through these issues, check out the Spring 1995 issue of the journal Contemporary Accounting Research, which provides a number of valuable review articles of the some of the relevant academic work.

It is impossible to address every conceivable objection in a short article in the Wall Street Journal or Slate, which is one reason we are writing our book. We look forward to picking up this debate in the fall when we lay all our facts and arguments on the table. Until that time, we have a little homework assignment for Gottlieb and anyone else at Slate who would like to try. Microsoft's earnings have grown at an average rate of about 25 percent annually over the past 10 years. Microsoft pays no dividends. Were all Microsoft's earnings consumed in running in place, as Gottlieb's model suggests? Should Microsoft be worth nothing since it doesn't pay an actual dividend today? Was the price increase over that period justified? What would a fair price for Microsoft be if the risk premium were zero? We look forward to their answers.


--James K. Glassman and Kevin Hassett

Bruce Gottlieb replies:Glassman and Hassett write in to say I have misrepresented their argument. They do not, they say, value a stock by looking at future earnings. They even agree that this would be a big mistake. They claim to look instead at future cash flows to stockholders. The two authors might want to reread their original WSJ article, which says: "Assume that after-tax earnings are a reasonable estimate of the cash flow from a stock." In other words, there is no difference between my description of their argument and their own.

Meanwhile, they have misrepresented my argument. My article does not say or imply that "real earnings growth only reflects retentions and that dividend growth must be zero" or that "all valuation techniques are out the window for firms that don't pay dividends." It simply asserts that, in calculating a firm's potential value, you can't assume that earnings are simultaneously retained and paid out--and that the Glassman-Hassett argument depends on precisely these conflicting assumptions. The argument is fallacious whether all the earnings are paid out, all are retained, or anything in between.

Glassman and Hassett now claim that they will sort out the components of retained earnings to avoid double-counting in their forthcoming book. I look forward to it. But I boldly predict it won't work unless they have an entirely new thesis, since double-counting of corporate earnings is the core of their current one. The thesis is simply wrong and cannot be refined into sense. What's more, double-counting of all corporate earnings is how they get the figure in their title--Dow 36,000--so that will have to go if they even start down Refinement Road.


It's obvious that our discussion must rest until this ambitious book is published. For right now, it is worth noting that this letter is the first place where Glassman and Hassett have explicitly admitted that equating earnings and dividends is a mathematical sin. They refer to it as "double-counting," which indeed it is.

Speaking With the "Enemy"

I've never read a more paranoid piece of writing then James J. Cramer's "A Message to My Enemies." At the risk of being lumped into Cramer's "legion of enemies," I thought it worth highlighting some of the absurdities in the piece.

Cramer writes that "[TokyoMex's] online following ... is much bigger than mine. And my record of giving good financial guidance, publicly and privately, is better than his. So why the fuss over me while other portfolio managers write every day about their stock picks and get no heat?" TokyoMex's activities deserve notice, but it's ridiculous to say that his following (via his own small Web site and Silicon Investor chat rooms) is bigger than Cramer's (whose thoughts have been distributed through not only TheStreet.com, but also ABCNEWS.com, Good Morning America, GQ, Yahoo! Squawk Box, SmartMoney, Time, and Politically Incorrect, among other media properties with vast audiences). TokyoMex may be unsavory, but Cramer just sets him up as a straw man to burn him. Just because Cramer is more ethical than an infamous pump-and-dumpster doesn't mean that his unusual position as both professional money manager and professional financial journalist--and yes, it is unusual--isn't deserving of scrutiny and criticism. The dual role is Cramer's gimmick, and more power to him for having the energy to exploit the possibilities inherent in straddling two worlds. I find his columns entertaining more often than not. But his situation isn't common, so the argument of "everyone does it, why pick on me?" isn't relevant.


Then Cramer says, "I don't write for the money, and I don't write for the notoriety, so giving them up wouldn't hurt." If it's true, then give up your $250,000 salary and your stock options in TheStreet.com, stop writing about your personal life in your musings, and remove the iconic projection of yourself from your Web site. You don't have to stop providing the insights that only you can give to the ignorant investing masses in order to forgo the money and fame that come along with your position. And, frankly, you shouldn't have to. But do us all the favor of not acting like you're just being noble.

Cramer continues, "[T]here is no difference between a portfolio manager who recommends stocks in an interview to a reporter ... and a portfolio manager who recommends stocks in a column of his own." Say what? Extending that logic, there's no difference between a government that promotes its policies to an independent press and a government that runs its own newspapers. The second of the two scenarios Cramer describes conflates the interested role of the portfolio manager with the presumably disinterested role of the journalist. Don't tell me there aren't ethical challenges in that beyond those posed by the first scenario.

Finally, Cramer writes, "The journalists who would stop me are complicit with that ignorance and are willing tools of those that would like the reader to have to rely on those who charge high commissions or high fees to unknowing, worried consumers of finance." This is a low blow. The general tone of Cramer's piece is dismissive of financial journalists (or at least those who would criticize him) as know-nothings or, worse, conspirers with the dark forces of the finance industry. But I've read Alan Abelson (the only "enemy" Cramer refers to by name) off-and-on since I first got interested in investing, and whatever else he is, he isn't a "tool" of the industry. Nor are the vast majority of financial journalists. Sure, there are some hacks, but most are intelligent folks who have the interests of their readers at the top of their agenda. Cramer notes that if investors don't find his writing worthy, he will "disappear from the writing firmament." Well, isn't that what would happen to the "established" business press that Cramer so disdains, if his accusations were even partly true?

I really do like TheStreet.com and Slate, and I have my own conflicts (I work for Morningstar, whose site at www.morningstar.net is a competitor to TheStreet.com, a supplier to MoneyCentral, etc.). But Cramer's screed didn't reflect well on your publication or his. Slate has been (unwittingly?) caught in the cross-fire that has been going on for a few years between Alan Abelson and James Cramer. It would have been better if your editors had dispatched the enviably good James Surowiecki to cover the feud, or if you had invited the two to duke it out in a "Dialogue." Luckily, I don't have to cancel my subscription to your zine in a fit of pique!

--Cebra Graves
New York City

Good and Necessary Evil

Terry Jeffrey perpetuates an old shibboleth when he mentions Bill Clinton's "safe, legal, and rare" comment regarding abortion (see "Dialogue: What Should the Republican Party Stand For?" ). Jeffrey asks how we could want any good thing to be rare. Presumably American involvement in World War II was a good thing--yet I doubt anyone would want it to happen again. There are other, less dramatic, examples; surely David Kaczynski's decision to alert the FBI to his brother's suspicious activities was the right choice. Nonetheless, few of us would want to face that decision ourselves--even if we are confident that we would have chosen similarly. Not all moral choices are painless. One can want a particular practice to be rare just because it is painful, even if it is morally required (and not just permissible). So there is no contradiction in wanting abortions to be safe, legal, and rare.

--Ananda Gupta
Bethesda, Md.

Terry Jeffrey responds:This rejoinder employs faulty logic. U.S. involvement in World War II was a good thing and, hopefully, not rare. I would hope that the United States would defend itself every time a fascist power bombs Pearl Harbor. Likewise, I would hope that David Kaczynski's good thing in informing the FBI of evidence bearing on his brother's guilt was also not a rare thing. I would hope that every time Kaczynski, or anybody else for that matter, discovers that a brother of his is an environmentalist extremist bent on murdering people, that he will inform the FBI of this evidence. If abortion, like defending oneself against fascists and environmentalist murderers, is a good thing, than it should not be rare. Good behavior should never be rare. It should be routine.

Time Is Money

I have great respect and admiration for Marshall Loeb (that's not a throwaway line; I really do), but his explanation that he was getting paid by Time, not the advertisers, is kind of funny (see "Culturebox: Dart"). Imagine how Slate and others would slice me up if you found out I was running a magazine about journalism--one that some call a "watchdog"--and was getting paid writing assignments from one of the organizations I was supposed to be watching and, of course, not disclosing it on the pages of the magazine whenever the magazine writes about that organization. You'd probably even get a great quote from Marshall saying how troubled he is by it. Might they cancel future assignments if a piece in the magazine really stings them? Might they add on assignments if a piece celebrates them? Mightn't it all just look bad even if everyone behaves honestly?

For you to let that explanation go uncommented on was surprising. Seems to me that getting paid by Time, as opposed to advertisers whom the Columbia Journalism Review is not nearly as likely to be covering, is a bigger issue.

--Steve Brill
New York City

Called on the Carpetbagger

In "The Out-of-Towners," David Greenberg says that "for some politicians, such as Arizona's John McCain, living in an adopted home state doesn't seem to matter at all." Actually, when McCain first ran for the House of Representatives, he was accused of being a carpetbagger. His reply was that, being a military child, he had moved around his whole life, and in fact, the longest he had ever lived in one place besides Arizona was when he was a prisoner of war for five and a half years in Vietnam! Needless to say, the accusation did not do for the competition what they hoped it would, as the reply was a large part of what won him his seat.

--James Wartell
Tucson, Ariz.