davefairtex wrote:
First- profits and growth:
It is possible to have profits without growth. Think about it. If you are adding value, you can charge for that. If nobody can charge for adding value, then all production of everything will stop. "Why on earth would I produce something for free?" Runs clean against human nature, and that state of affairs will not last very long. Likewise, profits don't require growth, and growth doesn't necessarily lead to profits. NFLX: lots of growth, no profits.
Profit comes from value add less costs. If something isn't profitable - over the long term anyway - it stops being produced.
The Milwaukee area company Ensync (formerly ZBB Energy) recently fired all its employees and was supposed to file a Chapter 128 in Wi. But no filing so far and the stock is still trading in the 0.01 to 0.02 range. Obama visited this company on his green tour. Check out Ensync’s historical financials…the losses are staggering. LOL!
While the author points out puzzling features of dividend-less stocks like Alphabet (and they are genuinely puzzling to me), upon closer inspection of his book I think he greatly exaggerates the importance of many points. One of the most exaggerated conclusions he draws is that the stock market is fundamentally Ponzi-like and his prediciton that it will end, permanently.
“At some point there will be one magnificent crash that will end the stock market permanently. The market will not be able to bounce back from it because unlike the dot-com crash or the housing bubble—which were blamed on indirect issues like failing businesses and bad loans—this last unrecoverable crash will be the result of something direct and fundamental: investors pulling their money out of the system as they realize the reality of the Ponzi Factor, and how their wealth is tied to the massive Ponzi scheme we now call the stock market. Little by little, the reality of the Ponzi Factor will sink in, and over time, it will become impossible to ignore. This final crash will change the face of our economic and financial system. Its destruction is unimaginable, but we will evolve from it.” (emphasis mine)
Before parsing out his book, I’ll draw your attention to Figure 11.2 from the book Irrational Exuberance, by Nobel laureate Robert Shiller. (See the link.) “Stock Prices and Dividend Present Values, 1871–2013 Real S&P Composite Stock Price Index, 1871–2013 (heavy irregular curve), and present values, 1871–2013, of subsequent real dividends calculated using a constant discount rate (dashed smooth curve)”
In the long term, the US stock market price really seems to be revolving around a discounted stream of future dividends, even if it can get way ahead, and way below that curve for decades at a time. (Consider that it’s log scale, so deviations are indeed large, even if they tend to mean-revert in time.)
(Dividends beyond 2014 are estimated based on a continuation of 2003-2013 dividends. “The need to make an assumption about real dividend growth after 2013 means that the more recent values of the dividend present value shown in the figure are unreliable as indicators of actual dividend present value. However, the numbers given for the dividend present value a couple of decades or more before 2013 are most likely fairly accurate, since for these years the subsequent years after 2013 are heavily discounted in the present value calculations.”)
Now consider this, from the book The Ponzi Factor, “(…) there are two ways investors can make money with stocks: dividends and capital gains. These two profiteering methods are fundamentally different. Profits from dividends come from the business, whereas profits from capital gains come from other investors. This is a material difference that regulators and people in finance ignore, but it is literally the difference between legitimate investment profits and Ponzi profits, and the difference between a real equity instrument and a gambling instrument.”
So the author thinks that capital gains are Ponzi profits. Think about how big an assertion that is. Now remember the figure I cited above. Since the start of the data in 1871, for close to a century and a half, some investors in the US stock market have been making capital gains, buying low and selling high, or “Ponzi profits” according to this author. But how reasonable is it to claim that buying a stock low and selling high is inherently Ponzi-like, when the net present value of the future dividend stream from stocks can change over time?
A share of the S&P 500 index was worth much less in 1926 than in 1976 partly because the discounted future dividend stream from it was worth much less. (Other factors are at play, too.) How Ponzi are those capital gains? How much does it resemble Madoff’s Ponzi scheme?
For all the fuzz the author makes about stocks not paying dividends, according to this page by NYU professor A Damodaran, the payout ratio for the S&P 500 averaged 38% for the 10 years ending 2017 (meaning that 38% of earnings were distributed as dividends), and 39% for the 5 years ending 2017. The ratio has been falling since 1960 but not too much; the average since 1960 is 45%. Also, the average dividend yield since 1960 has been 3.01%.
How do you reconcile that with this quote from the book?
“The majority of the stock market is made up of common stocks, which are basically notes with the company’s name on them, but they don’t guarantee any dividends or payments. In some cases, like with Google’s class C shares, which make up the majority of the company’s shares, they don’t even come with voting rights. Common stock shareholders are not entitled to any operational profits from the business, and the only practical way investors can make money is by selling their shares to other investors using the Ponzi process. There are exceptions, of course. Companies like Microsoft and McDonald’s have a history of paying regular dividends—whether the amounts paid are reasonable compared to the profits the companies earn can be subjective, but they do pay their investors on a regular basis. However, these are exceptions, and we can’t use exceptions to generalize what is the norm for common stocks in the overall market.”
Whether the dividends are guaranteed or not does not change the fact that around a third of earnings are in fact paid out, on average.
Quote:
“The Stock Market Is Similar To A Ponzi Scheme because it is a system where current investors’ profits are dependent on cash contributions from other investors. As I mentioned in the introduction, the Ponzi process is self-evident when we look at a typical stock transaction. When an investor buys a stock for $10 and sells it for $11 (a $1 profit), that $11 comes directly from another investor, and then that new investor will start looking for yet another investor who might want to pay $12 for the stock, and so on. The important thing to notice is that the underlying company doesn’t contribute any money into the transaction, and the company isn’t obligated to buy back their own shares for anything more than the par value of $0.001.
”
Quote:
‘If we define a Ponzi scheme as A system where current investors’ profits are dependent on cash from new investors, then the stock market is a Ponzi scheme. The Securities and Exchange Commission defines a Ponzi scheme as: “An investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.” Remove the opinion word “fraud” from the definition, and what do you have? The stock market.
’
But fraud is a necessary component of a Ponzi scheme, in my opinion. If you remove it from the definition, then gold meets the definition, but gold is not a Ponzi scheme (I think) and that’s part of the reason why for thousands of years it has carried on and not ended like all Ponzi schemes.
Why do all Ponzi schemes eventually fail and gold has not failed for thousands of years?
Ponzi schemes promise impossibly high and safe returns, so new investors’ money is quickly exhausted paying old investors.
Ponzi schemes involve deception, fraud. People think there’s an underlying economic enterprise that is the source of the returns, but there isn’t. Cash is simply shuffled around. So if the scheme is discovered, it’s in the interest of every “investor” to get their money out immediately as there is guaranteed not to be enough money for everyone, and the scheme collapses. With gold, there’s no deception. Everyone knows it’s a chunk of metal, and that the price can go up or down. No-one expects 5% monthly returns from gold.
In a Ponzi scheme, the underlying asset, if anything, is the cash that investors put in, and if I may simplify a bit, cash does not appreciate in nominal value. No-one wants to pay $110 for a $100 bill. Gold, however, is not like that. An ounce that was $1000 a few years ago can be worth $1500 today, simply because they are limited in quantity and people want them. Gold can appreciate in nominal terms.
My point is that the word “fraud” is not an optional, “opinion” word that can be dropped without anything being lost from the definition, and that something that meets most of the definition of Ponzi scheme but does not involve fraud, is likely not a Ponzi scheme.
Another way to look at it: If I buy a long-term bond issued today at $100 and the bond pays 2% interest, and tomorrow there’s a big change in interest rates and I can sell it for $120, those $20 are what the author would call “ponzi profits” because they are capital gains. In fact, you could even say that the entire $120 are ponzi profits, since the issuer has paid zero so far. But that’s not a problem, and ponzi is not even applicable here. The guy that pays me $120 only wants to get say 1.8% interest and is happy to pay $120 because he knows the interest is coming and it breaks even at $120. Even though the issuer has contributed nothing to my $120 revenue, the whole transaction makes sense and no fraud has taken place. The difference with dividend-paying stocks is that with bonds the interest is pre-specified in a contract, while with stocks you never really know what you’ll actually get. So I think he is wrong in saying that capital gains is an inherently fraudulent way to make money with stocks.
Another issue discussed at length in the book are the so-called “Tesla scenarios”: “A scenario where shareholders can make money from stock value appreciation during a period while the underlying company suffers extraordinary losses.” But Tesla is not “like” a Ponzi scheme, so long as the company has a fighting chance of ever reaching profitability and paying a dividend (without first diluting current investors into oblivion). Even if the only source of Tesla investor returns for now is cash from new investors, it’s not like a Ponzi scheme. Some Tesla investors really know what they are buying and are not being defrauded. (This is not to say that Tesla should be worth $330 a share, or that there is no bubble psychology at play with it. I don’t follow Tesla; I’m not a stock picker or analyst.)
“Tesla scenarios” are a poor way of making the case that the stock market is Ponzi-like. The company cannot reasonably pay a dividend since it’s not making money, but it does have a fighting chance of making money in the future and paying a dividend, so it’s not inherently unreasonable that investors are willing to pay more or less for that future non-guaranteed dividend stream as time goes on. What is unreasonable is putting money in a real Ponzi scheme and expecting that every other Ponzi investor can get their promised returns.
The book insists that the stock market (presumably in the US) is mostly composed of common stocks that do not pay dividends. (“History clearly shows that stocks were designed to pay dividends. But today, the common stocks that are being sold to investors behave nothing like the way stocks are supposed to function.”)
I got a list of the dividend yield of all S&P 500 companies from this page, and apparently all but 76 companies in the index have a dividend yield, and the companies that have a dividend yield comprise approximately 78% of the market cap of the index. Clearly even companies that do pay a dividend don’t pay all of their earnings, but they do pay some of them. So I’m not sure why the book repeatedly hammers the point that most stocks don’t pay dividend and therefore don’t have a monetary connection to their shareholders. So long as companies do pay a dividend in practice, there is a monetary connection between those companies and their shareholders (even if that connection can be cut at any time).
I agree that Alphabet and the other 75 S&P companies that don’t pay a dividend are suspect assets and that the author’s criticism applies more readily to them (at least to those that have earnings and don’t distribute them, which are most of them). But it seems that 78% of the S&P 500’s cap is in companies that have a monetary connection to their shareholders in practice.
The book also makes a big splash of the fact that the US stock market was valued at $36T in market cap (at the time the book was written), and that some people naively think that shareholders are on the whole entitled to $36T, when in fact there is $0 real cash backing the stock market.
Market cap is a curious concept and no-one should confuse it for real cash, because even though one person can sell his share of stock for close to the quoted price (by taking cash from another investor), all investors cannot simultaneously sell all their shares and raise in total $36T in cash unless the government prints it and buys all stocks with fresh cash.
However, this is also true of other markets, like the real estate market. Setting aside the fact that a lot of people own their houses because they actually want to live in them, those who own properties for rent should be aware that even if the sum of all property prices is $X trillion, there are $0 in real cash in the real estate market. If I own a property that I think is worth $100K, I can only get the $100K I think I own by finding someone who’s willing to give them to me for the property, and just like the stock market, all property owners cannot simultaneously liquidate their properties and expect to get anything if there are no buyers or government intervention. It’s not a perfect analogy but it makes the point. Obviously properties can be rented, but apparently companies worth 78% of the S&P 500 market cap also pay a dividend.
This is not to say that the US stock market should really be worth $36T (in market cap, which I said is a funny concept). Maybe it should only be worth 20% as much. Who knows. But I’m pretty sure it should not be worth zero, barring force majeure or the imminent threat of force majeure.
To put some numbers on it, at the end of Sep 2019 the 12-month real dividend per share of the S&P 500 was aparently 57.22.
The index was worth ~2976 then, so the dividend yield was 1.9%. If the market crashed by 80%, and if dividends and earnings held constant (which is not a realistic assumption, but let’s set this aside), then the dividend yield would be 9.6% and the earnings yield 22%. I suspect people would line up wanting to get 9.6% on their money, even if they didn’t count on capital appreciation. And if that was not enough, then a 90% crash to a 19% dividend yield should do it. The point is, while current valuations can fall, and drastically, there’s no reason to think that they can go to zero as long as law and order remain, because so long as there are dividends or even the future prospect of dividends, those should put a floor somewhere under the price of stocks, even if much lower from current valuations.
So the idea that the stock market will permanently end in one magnificent crash because it’s fundamentally Ponzi-like is, I think, ridiculous.
Those are my strongest points against the book, but I have some more tentative thoughts about dividend-less stocks like Alphabet. Alphabet has never paid and has no intention to pay a dividend in the foreseable future. Investors just want to hold Alphabet for the promise of selling it higher to the next ponzi investor. What if that willingness evaporated as investors realized that ponzi hope is not a good investment strategy? Alphabet stock would sink. But wouldn’t it be in Alphabet’s best interest, in that case, to announce that they would begin paying interest and raising capital in some other way? Maybe yes. So you could say that investor willingness to hold stocks that will not pay dividends is buttressed by knowing that companies can be “forced” to pay dividends if investors ever demanded it. It’s an implicit “guarantee” that dividends can be summoned.
So if alphabet is worth $100 and making $3.5 is earnings, if investors sold Alphabet down to $50 as part of a general sell-off of non-dividend paying stocks, Alphabet could announce that they will pay a $2 dividend and continue paying dividends, and it would make sense for the price to eventually recover to $100, since now a majority of the $3.5 earnings would be recoverable via dividends going forward. The earnings would still be there, but now most of them would be distributed as dividends. If investors were valuing the discounted future revenue stream, now they can continue to value that.
So you could think that investor psychology goes like this, “look, I want to hold Alphabet as long as they are making earnings and it looks like they have a bright earnings future ahead of them. They can reinvest all of the earnings and give us none. I think that investors will continue to want this arrangement, but if they ever change their mind, I am safe knowing that it would be in Alphabet’s best interest to change course, begin paying dividends, and then the price would recover, because instead of reinvested earnings, the company would now hand out a big part of earnings as dividends.”
I’m not firmly behind this view, but I think it’s somewhat of a counter-balancing point.
If a company contractually committed to never paying any dividends or buying back their own shares and made it impossible for it to ever change that commitment, then yes, that company’s stock should not be worth anything, since it can only ever go bust, but it cannot ever return a dividend. So to the extent that the stock is worth anything, you can know that something fishy is going on. But Alphabet, Berkshire, they are not like that, at least not according to the author. Alphabet says that they “do not intend” to pay a dividend “for the foreseable future.”
And finally, while this has nothing to do with his main argument, I couldn’t resist sharing this quote from the book:
“Ultimately, it’s all about legitimacy. A real estate transaction has legitimacy because the value of the property is backed by the physical value of the property itself. The value of a dollar has legitimacy because the value is backed by the United States government.”
The book’s starting and ending quote is this:
“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as self-evident. —Arthur Schopenhauer”
One thing that won’t go through Schopenhauer’s stages is the idea that the stock market is inherently Ponzi-like. It won’t get past the first stage, because it’s not true. No need for violent opposition. The body guards can be called off.
In sum, the book is deeply disappointing if you can see past superficial but irrelevant similarities between stocks and Ponzi schemes and if you check the numbers.
