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Quarterly Letter to Clients

July, 2016

Indices at quarter-end (June 30, 2016):

Dow Jones Industrials: 17,929.99 2Q'16 +1.38% YTD +2.90%

Standard & Poor's 500: 2,098.86 2Q'16 +1.90% YTD +2.68%

I don't know if you can call it dull, with all of the wrenching ups and downs, but after six months of churning, the markets have gained less than 3%, about as much as they might in a single brisk day. Still, it is a gain, and we should be happy.

For the most part, the second quarter was less volatile than the first quarter, as stocks finished climbing back out of the hole and then leveled off. Then the Brexit vote came in, with Britain voting to leave the EU. Stock markets, which view uncertainty as anathema, registered their displeasure and tumbled big. Still, other than a few dramatic days, it was a calm quarter.

Here at home, the Fed has again delayed taking any action; rates dropped a little, meaning that bonds edged up. There is not much more “little” for rates to drop, with the 10-year treasury yielding below 1.5%.

The relative quiet gave me time for philosophical contemplation, for which I apologize in advance.

I think in decades, and it recently occurred to me that perhaps I was getting a little long in the tooth to be thinking in such terms. But money is more than a life-long marathon, it is a multi-generational thing. Though your assets may be dinged by inheritance taxes, end-of-life medical expenses and so on, proper stewardship will enhance the lives of generations to come, even if your assets are not huge. So, no matter your age, when considering any investment, you should be looking out ten, twenty or more years, because it is near impossible to see what will happen to prices over any shorter term.

What we can rely on is that, over time, currencies will be debased; good companies will likely earn more money; their stocks will probably sell at higher prices; and, hopefully, they will distribute more in the form of dividends.

You may not think of dividends as a significant reason to buy stock, but it has been shown that dividends are extremely important, accounting for around 40% of long-term performance. If a company pays no dividends, then there are only two reasons that someone might buy that stock: first, for the prospect of a dividend in the future; and second, in the hope that the price of the stock will increase.

This latter reason might look suspiciously like the "greater fool" theory: in a nutshell, that someone even more foolish will come along and buy the asset from you at a higher price than you paid. This is a little over-simplistic, as some of my best performers have never paid a dividend. But think about it: if there is no chance of sharing in the earnings of the company, why would anyone ever buy a stock?

In recent years the term "returning money to shareholders" has become popular. You might think that this phrase refers to dividends, but no: the main method being used to return money to shareholders is by buying back stock and retiring it. The number of shares outstanding thus shrinks. When each dollar of earnings is then spread over fewer shares, the result is higher earnings per share (EPS), in theory leading to a higher stock price.

My problem with this philosophy is that the companies are not exactly returning money to shareholders; they are giving it to sellers who are then no longer shareholders. And any beneficial effect on the price of the stock is extremely fleeting.

Why would a company do something like this? The reason is that the earnings and bonuses of top management are often dependent upon the simple metrics of earnings-per-share and/or stock price. Thus we see that a number of companies whose absolute-dollar earnings may run flat for several years nevertheless are able to increase earnings per share over that same time period.

Conceivably, companies could use those same funds to pay down debt, an action that would also increase EPS. Why don’t they do that? Because interest paid is a tax-deductible expense. And while the effect on EPS would be positive, it is not quite as positive as reducing the share count.

Paying down debt would be beneficial to all shareholders, strengthening the balance sheet and also increasing earnings per share. Paying down debt is a long-term strategy. Too many companies today are managed for the next quarter rather than for the years ahead. Leave the daily swings to the gamblers; as investors, we should instead be focused on the decades to come.

File this information along with our previous discussion of “adjusted” earnings. Both practices are often referred to as financial engineering, but financial sleight-of-hand is an equally descriptive term. When investigating stocks, look only at true (not “adjusted”) earnings, and look for companies that are increasing their dividends and/or paying down debt. Then you can invest with confidence for the long term.

Jim Pappas