Sunday, February 11, 2007

It’s a Great Country, Especially if You’re Rich


THIS is a column about two vital investment notions.

First, much has been made lately of stock buybacks by public companies. A stock buyback, as the name implies, occurs when a company uses its cash to buy back its stock. There has been a staggering amount of this stuff going on lately.

In 2006, according to Phil DeMuth, my friend, book-writing partner and investment wizard, stock buybacks by the largest American corporations were roughly $325 billion, an immense sum even when compared with, say, 2004, when they were closer to $200 billion, itself a vast sum.

The criticism of these buybacks is that they reduce the number of shares outstanding at Company X, and earnings are therefore spread over fewer shares. This raises earnings per share, and — in a good market — presumably raises the price of the shares, all other things held equal. This, in turn, makes the value of the options held by executives rise. So, supposedly, this makes share buybacks suspect.

But I would like to offer a few more thoughts on share buybacks and then hit that one.

When Company X buys back its shares, it is essentially saying that it thinks the investment is a good use of the company’s money. Thus, if the company is selling at a price-to-earnings ratio of 20 — a normal state today, implying a 5 percent annual profit — management is saying that it has enough cash so that it is happy to invest in something paying a 5 percent return.

The market as a whole is trading at about 20 times earnings, so the business community as a whole is saying it likes investments yielding 5 percent. This is discouraging. Historically, 5 percent is not an especially good rate of return on invested capital. The leaders of very few of America’s companies would jump for joy if you were an employee and brought them a new project whose yield would be 5 percent per annum.

Years ago, the investor and entrepreneur Roy L. Ash, a co-founder of Litton Industries, said that his company liked investments yielding more like 12 percent. Henry Wallich, my finance professor at Yale, said a long-term yield of 10 percent should be considered the threshold for a project.

That our companies are happy with 5 percent is not a good sign for investment opportunities. The decline in returns may have to do with the vast accumulations of capital in this society.

As the classical 18th-century economist Adam Smith and his 19th-century disciple David Ricardo intuitively recognized, as societies acquire more capital, the return on that capital falls. That may well be what’s happening in the United States. If so, it’s a not a great portent for stock market returns over the long haul.

Next, it’s true that buybacks can raise the value of stock options held by management. But there are two big mitigating factors:

First, buybacks do not benefit only managers; the earnings per share of the stocks owned by us pound animals known as public stockholders also rises. Unfortunately for us stray animals, we don’t get options triggered by reaching certain earnings-per-share goals as our betters up at the manor do.

(And, of course, the fundamentals of most businesses are not really improved by buybacks, which is what the options are supposed to be all about. But by now, that’s an old story in these columns.)

Second, while markets sometimes like buybacks, sometimes they dislike buybacks as a totem that a company has matured and has no better use of its money.

In other words, buybacks are not a sure thing to move a stock.

Finally, there used to be a truism that stock buybacks are a tax-favored form of paying investors. If the buybacks raise the stock price, they make money for the investors that was once taxed at favored capital gains rates, as compared with dividends.

But now, under the Bush tax regime, most dividends and long-term capital gains are taxed at the same gloriously low rate. Thus the rationale of a tax advantage for the buyback vanishes.

It all seems complicated. (None of this would ever happen inside the gates of Eden.) But maybe corporations are simply flooded with money.

My seer, Phil DeMuth, found out for me that the members of the Standard & Poor’s 500-stock index alone had more than $2.6 trillion in cash and equivalents at the end of 2006. That is a stunning amount.

The corporations simply do not know what to do with it. No one is going to call them insane if they buy back stock, and thus they cover their backsides while possibly feathering their nests.

(There is another interesting aspect to this: the immense mass of stock that is owned by the wealthiest 10 percent of families in this country — by some measures as much as 80 percent of all stock. And a very, very large portion of it is owned by the wealthiest 1 percent of families. In fact, the upper 1 percent owned about 44 percent of financial assets in 2001, the most recent year for which I could get data.

(If you said that the $2.6 trillion of cash owned by American corporations was yet another asset of the very rich, you would not be terribly far off. This makes it a bit sad — no, heartbreaking — for the roughly 80 percent of Americans who have no or virtually no savings.)

Or, to put it yet another way, this is a great, magnificent country, beyond all reason, with the doors of opportunity open to all. But it’s really, really great for the rich.

NOW, I said that this was about two investment thoughts. Here’s the more important one.

My wife is a saint. She is a living, breathing saint. She is good-natured, patient, helpful (she cleans out the icky cat litter boxes and bathes our pitiful three-legged adopted toy poodle), and she has put up with misconduct by me on a scale that is beyond imagining.

We have been together for decades, and for decades she has wanted a big diamond ring. I thought of every excuse I could for not getting it for her: let’s give the money to charity, what about our old age, what about our dogs’ old age, the cats’ old age and so forth. Finally, two years ago, I gave in and bought her a big diamond that I could ill afford.

It makes her so happy that I feel like an idiot for not having done it sooner. She looks at it endlessly, twirls it around and around her finger, loves it, worships it.

Now, bear in mind, most of her waking hours are spent helping animals through the International Fund for Animal Welfare. She is a charitable, saintly woman. But human beings like tokens of affection. She’s a saint, but she’s a human being.

In a few days it will be Valentine’s Day. Don’t mortgage your future, but if the last few years have been good to you and if you have given what you should to charity, make the investment in your spouse or significant other.

The return in her happiness, as far as I can tell, is beyond counting — and tax free.

When you’re out of town, when you’re under the ground, that stone will still be there on her finger — and in a way, you will be, too.

Ben Stein is a lawyer, writer, actor and economist.

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