Shares go on trial

By BRENT SHEATHER*

Back in 1998-99, when shares could do no wrong, academics and other experts were regularly publishing reports validating the current level of the US sharemarket and offering plausible (then anyway) claims that the Dow-Jones index could reach the 36,000 level and beyond.

Those days are gone. Now the trend is very much downward, not up.

Predictably, the experts are now publishing weighty tomes arguing that the current slide is not only justified but merely represents a precursor of worse things to come.

What is the poor investor, saving for his or her retirement, to make of this concerted attack on shares? Was Sir Robert Muldoon on to something when he said "bank deposits are best" on those TV advertisements years ago?

In the past few months, various US companies and their executives have been revealed as fraudsters. But is the whole idea of buying shares for the long run just another fraud on a larger scale? Below we review the evidence for the prosecution.

The case is particularly intriguing because a few of the more prominent prosecution witnesses are share fund managers themselves. Furthermore, some of their arguments challenge the very basis of share investing - that shares will outperform bonds in the long run.

The case has had some publicity overseas but many New Zealand investors will be blissfully unaware of these challenges to the dominant role of shares in savings portfolios. Most local fund managers, financial planners and stockbrokers keep their eyes tightly closed and their fingers crossed for better days.

There is a lot at stake: an unfavourable verdict in this case would be disastrous for stockbrokers, fund managers, financial planners, pension fund consultants, etc.

Managing shares is a profitable business but bonds offer far less in the way of management fees. Nobody wants this game to end, but the harsh reality is that low, single-digit returns will not sustain either the local or international savings industry in its present form.

So what is the evidence for the prosecution? Foremost among the heretic anti-share camp are two investment managers/academics from the US - Robert Arnott, whose firm, First Quadrant, manages US$15 billion ($30.3 billion) out of California, and Peter Bernstein, a New York economist, author and adviser to some of the world's biggest pension funds.

Arnott and Bernstein co-authored a report published in the March/April edition of the Financial Analysts Journal which has attracted a great deal of attention. Their report argues that shares will outperform most other investments, but only if they are favourably priced at the start of the race.

If you buy into a market where price-earnings ratios are too high or dividends are too low, your returns will be no better than you would earn on low-risk bonds.



The implication is that back in 2000, shares were fundamentally overpriced and until they finish "correcting" - i.e. falling - we are not going to get returns anywhere near those of the past.

The argument that shares are either overpriced and/or destined to produce returns on a par with bonds goes something like this: for the past 100 years, US shares have returned about 6.7 per cent a year, after inflation. Ask 100 share investors why that is so and 99.9 per cent will say "because company profits grew at that rate and prices followed". A great theory, but it just isn't so; the 6.7 per cent was primarily made up of a starting dividend yield of 4.2 per cent, rising price/earnings ratios added 2 per cent a year and real dividend growth over 100 years was only 0.6 per cent a year.

If dividend yields in the US today are around 2 per cent, price/earnings ratios don't rise any further, and dividends grow as fast as they have over the past century, then in future shares should return just 2.6 per cent a year after inflation. Or, before inflation, a nominal return of just under 5 per cent a year.

The horrifyingly low dividend growth has also been confirmed by a British study, written by three London Business School experts and entitled "Triumph of the Optimists".

The study calculates returns for 16 major stockmarkets over 101 years. In real terms, averaged out over the entire sample, dividends fell rather than rose.

At this point in the case against shares, the defence counsel might point out that dividend yields are very low simply because companies retain much more of their profits than they used to. Microsoft, for example, doesn't pay a dividend at all.

But Arnott and Bernstein saw this one coming and answered by showing that most companies which retain lots of their profit end up squandering it on bad projects and silly takeovers (Fletcher Challenge, Brierley, Carter Holt and Telecom shareholders may be able to empathise with this view).

In another article, Arnott writes: "Investment theory says that retaining more earnings should, in a perfect, efficient, rational and taxless world, lead to additional growth which exactly offsets the reduction in dividend yield. The real world doesn't work that way. When industry at large is retaining more earnings, the subsequent growth suffers badly."

Just to be sure, Arnott and Bernstein also calculated the real growth in earnings per share of US listed stocks since 1871. The result? A meagre 1.4 per cent a year.

What does all this mean for someone saving for retirement?

While the prosecution's case against US shares is a pretty good one - and it certainly does suggest that at its peak, the US stockmarket was ridiculously priced - the case against shares is not proven internationally.

Other markets have higher dividend yields (New Zealand shares, for example, yield about 6 per cent to local investors). Furthermore, since their peak, US shares have fallen by about 45 per cent and there is growing pressure on companies to pass back profits to shareholders. Jeremy Siegel, a prominent US economist, is apparently urging the Bush Administration to make dividends tax-deductible, which would cure many of the valuation problems and corporate governance concerns overnight.

In any case, what choice do investors have but to invest in shares if they want to protect the value of their savings and the income it produces from inflation? None really, especially if you believe in the value of diversification. After tax, bonds haven't achieved returns consistently above inflation - indeed, when prices rise rapidly, bond prices crash.

A key defence witness, US broker Morgan Stanley, produced evidence that although the outlook for shares was admittedly poor, bonds have produced even worse returns in times when interest rates were as low as they are now.

The conclusion that most professional investors appear to have reached is that while shares are still okay, they should not make up such a big part of portfolios as they have in the past, which suggests a greater role for bonds and property.

Despite the hype, institutional investors don't appear to believe that hedge funds offer a real alternative to shares.

A recent report in Britain disclosed that British fund managers have been consistently swapping shares for bonds since 2000, a process which appears to have sped up lately.

Though shares have avoided going "inside", the "not quite guilty" verdict still has enormous implications for the many individual investors who took advice from financial planners and stockbrokers in 1999-2001 when shares were in the ascendancy and bonds were for sissies.

Many Mums and Dads in this period have, after having their risk profile assessed, walked out the door with portfolios which were 70 or 80 per cent and more in shares. Their financial plans assumed that recurring capital profits would pay for their retirement needs, while the meagre income produced went in fees.

Anyone who is newly retired and who has a large proportion of his or more money in shares faces a hard decision: stay with a high-risk portfolio and hope for the best or acknowledge the mistake and rebalance towards something like the asset allocation the average pension fund uses - 40 per cent bonds, 10 per cent property and 50 per cent shares.

As someone who has followed the trial of equities with interest, my vote would be to play it safe and rebalance.

* Brent Sheather is a Whakatane investment adviser.