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A Seat at the Slots

Richard Quinn

WHAT DO HIGHER corporate profits truly mean to investors? Or, put another way, this 77-year-old neophyte wants to know, “How is investing in stocks different from gambling?”

Don’t get me wrong, I invest in stocks and I understand they’re the best way for most of us to grow wealthy over time. What I don’t get is, “Why? What causes a stock to increase in value?”

I’ve researched the question and what I find is a lot of talk about earnings per share, price-earnings ratios, earnings growth and such. But rather than answering my question, this stuff about earnings, valuations and so on leaves me even deeper in doubt.

One Sunday evening, I looked at the S&P 500 futures. They were up. But on Monday morning, the market tanked. What happened? Some news that had nothing to do with the value of any individual company, I suspect.

I own shares in my old employer. It’s a utility that’s been around for 110 years and pays a decent dividend. The stock price bounces around from day to day and yet nothing significant at the company changes. For the current quarter, analyst estimates of earnings per share range from $0.31 to $1.04. Should I be concerned? As long as the company pays its quarterly dividend—and continues to pay my pension—should I care about the latest quarterly earnings?

I’m told earnings, or the anticipation of higher earnings, drive share prices. But if I don’t get paid my share of those higher earnings as dividends, why pay more for the stock? Somebody is gambling, I think, but I’m not sure on what—except perhaps on higher price-earnings ratios.

I tend to view the changing value of a stock like art. I’m an artist of sorts, albeit a mediocre one, as you’ll see from the picture below. But if I could get one critic (think analyst) to say a few kind words, someone might buy my art. Then some other sucker, I mean, investor might pay even more, and I’d be on my way.

Picasso and Rothko seem to have done well after a good word or two. How many people understand their art? Why buy a stock for many times its earnings when value seems to be in the eye of the beholder?

On top of that, we have the difference between analysts’ earnings predictions and the actual results. A company meets, beats or doesn’t meet those quarterly estimates and the stock goes up or down. Why do we assume those analyst estimates are valid?

As I read an article about the best dividend-paying stocks for 2020, I scanned analysts’ opinions of each stock. One caught my eye. Four analysts had the stock as a “strong buy,” two as a “buy,” 12 “hold,” two “sell” and three “strong sell.” I guess they use different dice.

Increasing dividends are good. But many companies see their stock price rise, even though they pay no dividend. Investors are paying more for a stock because corporate profits are rising and yet those earnings aren’t getting shared. Yes, I get it, the earnings are being reinvested in the business, supposedly to enhance earnings down the road. But if that cash isn’t coming back to shareholders, why should I pay a higher price for the stock?

About those earnings: It doesn’t seem to matter how they increase. If earnings increase because sales are up and hence profits are up, that’s one thing. But if earnings increase because of workforce reductions or other cost cutting, that doesn’t impress me. Actually, it makes me wonder who was minding the store. How did the company get to the point where staffing and other costs were so out of control?

I read one explanation of rising stock prices that discussed the law of supply and demand. One person wants to sell and another is willing to pay more to buy. But why? Oh, I know, because earnings are expected to grow, so the stock will be worth more in the future. Isn’t that a circular argument?

While trying to figure all this out, I came across this: “[A] stock could… be considered overvalued if prices continue to rise, despite earnings falling short of predicted growth estimates. An overvalued stock is the opposite of an undervalued stock. When a stock is undervalued, it trades at a share price that’s below what the stock is actually worth. ”

Profound, right? So I guess I have to figure out what a stock is “actually worth,” and that seems to have something to do with “predicted growth estimates,” which doesn’t seem to have anything to do with putting cash in my wallet. My head is starting to hurt. How about just sending me a nice dividend check instead?

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Want $870,000Taking Credit and Do as I Don’t. Follow Dick on Twitter @QuinnsComments.

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J Cp
J Cp
11 months ago

I too have tried rationalizing holding stocks. My mental experiment is thus: A company is formed and I am in at the IPO. It grows like mad and is profitable but hoards its cash so that I get nothing back but all the while others are hopping on the wagon and driving the price up.

After the 30 years it goes broke leaving nothing to shareholders. Somewhere between the IPO and bankruptcy the company made profits but none were returned. Was I gambling?

There was always the chance I suppose that a dividend might be paid or share repurchases were made or maybe even a takeover for cash.

R Quinn
R Quinn
11 months ago
Reply to  J Cp

Or maybe you sold along the way and let somebody else throw the dice until the next buyer comes along 🤑

Pravin Mittal
Pravin Mittal
11 months ago

You should look up Modigliani and Miller dividend irrelevance theory with assumptions they made such as no taxes, no asymmetric information, no bankruptcy risks, agency costs etc. They were awarded nobel prize for their effort. I point out assumptions as they may not hold true in real world but allows to analyze understand the difference. For example, taxes on dividends are real so it does creates a drag.

R Quinn
R Quinn
11 months ago
Reply to  Pravin Mittal

So are you saying it’s not dividend we want, but higher stakes gambling? I don’t doubt stock price increases can provide the larger return, but that gets us back to why and seems to reinforce the gambling scenario.

parkslope
parkslope
11 months ago

A key difference between casino gambling and investing is that the “deck” is stacked in favor of investors, especially if you invest in low cost index funds.

Scrooge_McDuck88
Scrooge_McDuck88
11 months ago

I really enjoyed this article Richard. Fun mental gymnastics!

parkslope
parkslope
11 months ago

I think it is a fallacy to think that owning stock in dividend paying companies is necessarily safer than investing in non-dividend paying companies.
https://www.dividend.com/dividend-education/the-biggest-dividend-stock-disasters-of-all-time/

Roboticus Aquarius
Roboticus Aquarius
11 months ago
Reply to  parkslope

Agreed. You can create your own dividends by simply selling a share or two on a regular basis. The (cap gain) tax treatment will actually generally be better than receiving a dividend (normal income). Total return is not affected by whether the company pays you directly via dividends, or not at all. Those of us who have seen the swift re-valuation of shares upon receipt of dividends have zero doubt on that score.

Some people enjoy the idea of a dividend; it can make the mental accounting easier to conceptualize… or they may have circumstances where the tax treatment issue is moot or resolves favorably… or they like the convenience of dividends automatically deposited in a spending account.

I think people should do what works for them. It should not be a surprise when that involves some differences in conceptualization. However, it’s important to understand the concept, so that one doesn’t think their dividends provide some kind of investing super-fuel. In the final analysis, all roads lead to Rome (total return.)

R Quinn
R Quinn
11 months ago
Reply to  parkslope

I don’t think it’s about safety, but about the validity of making money without the gambling aspect or at least a lower level. It’s more honestly sharing the profit

Roboticus Aquarius
Roboticus Aquarius
11 months ago

I realize so much of the post was tongue-in-cheek, and it’s a fun read I think every experienced investor can appreciate.

I do have a bone to pick on the view of market investing as ‘gambling’ (not directed at this particular blog post as I hope my first sentence makes clear), so here goes: This discussion always makes me question why more people don’t promote alternative economic systems. As long as you invest in the total market, it should be clear that investing in the market is not gambling.

Imo, if you believe that the stock market is “gambling”, then you don’t believe in the market mechanism. There is no value creation… and capitalism is an ineffective system (or else, you believe management is suckering the owners and taking all the value for themselves, or giving it all away to the customers, either of which would also be a fatal indictment of capitalism.)

The evidence, of course, suggests capitalism creates value. (The extent to which it does so equitably is a matter long under discussion, and not for these pages.) People will pay for value. That drives stock prices. The fact is that valuation is a tricky game for so very many reasons (again, too many to list), and the resulting volatility causes people to misclassify what they are seeing. It’s not random. It’s volatile, with a long-term upward bias.

Two scenarios with very different implications regarding what to do with your personal stash of value. Stepping down from soapbox…

R Quinn
R Quinn
11 months ago

Was the point of this post missed? It’s not about the dividends, it’s about why will you buy a stock I want to sell. If you say because you believe the price will go higher, I ask why. If you say because it’s earnings are rising, I ask how does that make the stock more valuable to you… and to the person you will eventually sell the stock to? In the absence of dividends there is no value except that created by the expectation of … what?

Langston Holland
Langston Holland
11 months ago
Reply to  R Quinn

As earnings grow with increases in demand and productivity, the value of the company grows (holding a bunch of stuff constant). As the value of the company grows, so grows the value of the whole pie that it’s a piece of – the market. Stock investors own a piece of that growing pie. Of course, their individual piece(s) may not grow, but the pie as a whole, that’s another matter. So far. 🙂

Sure it’s all vapor with stocks that don’t pay dividends – in a way – at least until you convert the stock into money by selling. Each of us, whether we calculate it formally or not, make a present value assessment of an investment whether it pays dividends or interest or nothing at all until we sell it. Waiting longer for your hoped-for profit means you demand a higher rate of return. The time value of money. Money is our modern proxy for everything we need and want to isolate us from portions of our environment we don’t like. Such as hunger, poor health and risk.

You certainly made a great case for low cost market index funds whether you like it or not! 🙂

Why bother with the components when you can eliminate their individual risk and buy the whole pie? Then go have a life as you add to the funds and walk away from the slot machines that are rigged for the house.

Earnings are a reliable predictor, but only over the long term and for the entire market. GDP is a reasonable proxy. Then add inflation. Then add dividends. This fancy math care of Warren Buffett.

He assumes long term US GDP at 3%. I’d add 1.5% for inflation and 1.5% for dividends over the next 10 years and expect about 6% total return.

What if it’s 5% or 15%? What if the US becomes socialist? What if, what if? The fact is, if you want a good shot at beating inflation with your savings, there is no where else to go other than stocks and your human capital (the best bond you will ever own).

Great article! You made us focus on the most important question there is: Why? 🙂

Stu
Stu
11 months ago

The system works as long as someone thinks that they can resell the Tulip at a higher price later..

Steve Spinella
Steve Spinella
11 months ago

I appreciate your reflections. Markets are certainly an imperfect mirror! I would say that current market prices mainly represent what it will cost me to buy a piece of the company today, or what someone will give me for the piece I already own. Regarding your utility and former employer, you might want to buy a different utility since you are already counting on this one for your pension. A lot of people forget to think about their wages or pension when they’re considering diversification. My accountant friend reminds me that financial statements are also somewhat aspirational rather than strictly accurate–they tell us what the accountants and their CEOs want us to know in the way they wanted to tell their story.

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