Newsletter June 8, 2002


Why long term market average returns will likely not exceed 7%

Warning – Average returns sometimes do not reflect typical or normal returns

Does the Average Investor Self Report Capital Gains for Taxes?

Income Tax Fairness

Income Tax Police

Nortel and Share Dilution Nonsense


Boardwalk Equities and Canadian Western Bank are both updated. Both seem to be solid investments with little chance of permanent loss of capital and good prospects for share price increases.

I hope to focus on getting more updates done for you in the next 2 weeks.

Why Long Term Average Stock Market Returns Will Likely Not Exceed 7%

Warren Buffett in articles in Fortune magazine (November 22, 1999 and updated December 10, 2001) argued that long term stock market returns will be about 7% (including dividends) going forward.

In essence his argument was as follows.

Your return on stocks will made up of two components:

1) An annual dividend yield
2) A capital gain (or loss) over a holding period.

As of April 30, 2002 the DOW Jones Industrial Average (“DOW”) had a dividend yield of 1.6% Historically it used to be much higher but has been in long term decline as companies retain more earnings.

Let’s be a little generous and assume it will stabilize at 2%. So that gives you a 2% return from dividends.

The capital gain return can be broken out into two parts. Stocks trade at a Price  divided by Earnings (“P/E”) ratio or multiple. If the P/E remains constant and earnings rise then you get a capital gain since the stock price rises. Further if the earnings remain constant but the P/E multiple increases (usually due to an increase in expected earnings growth) then you get a capital gain that way.

As of April 30, 2002 (latest summary data on the DOW site) the P/E of the DOW was 19.8 based on forward projected earnings. The long term P/E average since 1951 has been 18.3 so we are just a bit higher now than average.

If we assume that the P/E will remain around the current level in the next decade or so, then we will not get any capital gain from a P/E multiple increase.

Therefore our capital gain then must come exclusively from earnings increases and the stock price increase will be exactly proportional to the earnings increase.

Now, how fast will earnings increase?

Warren argues that on average we cannot expect earnings to increase any faster than GDP in nominal (as opposed to real or inflation adjusted) dollars. Warren notes that total corporate earnings as a percent of GDP tend to fluctuate in a range from 4.5% to 6.5% and in 2000 were at 6%. He argues that corporate profits will not increase faster than GDP because that would imply corporations grabbing an increasing share of the total pie and he does not think that would fly politically.

So he believes that earnings will increase at about the same rate as GDP and GDP is projected to grow at no more than 5% including 3% real growth and 2% for inflation. This will give you a 5% expected return per year from share price increases in response to the 5% average annual earnings increases.

Your total expected return then is 2% for dividends plus 5% share price gains for a total return of 7% per year.

If you thought you should get at least 10% returns from stocks, the problem is that the only way to justify a 10% long term return is to make rather heroic assumptions about earnings growth or to assume that P/E multiples will move well above the historic average.

I’m sorry, but the math indicates that the long term average return on stocks will only be in the range of 7% going forward.

Now you may say, this simply seems inconsistent with the big returns of the last 20 years. But consider that from 1981 through 2000, the earnings on the DOW increased by only a compounded 7.15% annually. Still, the DOW returned a compounded 16.5% during that period mostly because of a huge increase in the P/E ratio from an almost historically low 7.9 at the start of 1981 to 22.2 at the end of 2000. This wonderful P/E  expansion was due to a combination of 1) a huge decline in long term ten year government bond interest rates from 11.43% at the start of 1981 to 6.03% at the end of 2000 and 2) a general increase in optimism about future corporate earnings growth. Neither of these two factors can be expected to contribute to a further P/E expansion going forward, In fact their is a strong risk now that these two items could continue their very recent reversal, with sickening results.

Warning – Average returns sometimes do not reflect typical or normal returns

An editorial by Paul Kedrosky in the National Post today, Saturday, June 8, described how the average return on private equity funds (venture capital and buyout funds) has been  20 to 25% over the last 20 years but the median fund returned a lousy 2%! Fully 50% of funds returned 2% or less even though the average was over 20%. The reason for the discrepancy is that the average is skewed by a few funds that scored over 1000%.

In this case an average investor in a single fund was more likely to see a 2% return than a 20% return.

It’s clearly important for investors not to be mis-led, by averages that mean little or nothing. The following examples are illustrative.

As Mr. Kedrosky points out in his editorial the average person has slightly less than 2 hands (essentially none have more than 2, a good number worldwide have 0 or 1 hands and the average is clearly slightly less than 2). A typical person has precisely 2 hands and that is different than the average.

Consider weather reporting. We constantly hear remarks such as the normal high temperature for June 8 in Edmonton is, for example, 17 degrees Celcius. Then if the actual temperature is 14 degrees, weather announcers imply or say that this is abnormal. But they are mixing up “normal” with “average”. If the average is 17 but has a standard deviation of 4 degrees then that would mean that statistically about 66% of the time the temperature is between 13 and 21 and 34% of the time it would be outside of that range. In that case there would be nothing abnormal or atypical at all about a temperature of 14, it would be well within the normal range. But weather announcers seem to think that normal and average are the same thing, they most certainly are not. That’s why smart travelers to Edmonton in June should pack both Tee shirts and a light jacket, either could be needed under completely normal conditions.

Canadians would be better informed if weather forecasters also gave the range of normal temperatures for a day such as the range that the temperature is expected to fall within 90% of the time.

As humans, we automatically assume that if the average return on an investment is 20%, then we will most likely make 20%. But we need to understand the variance around that. And if the average is skewed by a few extremely high outliers, we need to understand that the typical or median return might be far lower than the average.

The point is, always dig deeper than the average return and look at the median return and the distribution around the median.

Does the Average Investor Self Report Capital Gains for Taxes?

A question I have long pondered is do Canadians typically self report their taxable capital gains on stock trading? When you make capital gains on trading individual stocks you do not get any tax slip to help you report it. You are on your own to figure out your capital gain and then to self report it.

Perhaps almost everyone does report these gains because they are honest and because they fear being caught if they don’t report. Most of us are honest but let’s face it if we thought there was no chance of getting caught or if the penalty for getting caught was very low, most people would not report it. For example does anyone seriously think that servers typically report all of their cash tips?

Most of us are on salaries and are used to reporting the income that shows up on a T4 or T5. I believe that most people are much less inclined to report cash income.

I don’t know how likely it is that the government is collecting information on stock trades and would catch you if you failed to report. I also don’t know the penalty for not reporting.

I should not generalize but I find it hard to believe that the average day trader is the type of person who would self report capital gains.

Please indicate what you think with the following “voting buttons”

Do you believe that at least 75% of traders are duly reporting  their capital gains?

Please “vote”, unless you have no opinion.
YES (at least 75% likely properly self report capital gains from stocks) or
NO  (less than 75% likely properly self report capital gains from stocks)
I’ll give the results next issue.

Income Tax Fairness:

On the subject of self reported income taxes, here are some interesting points.

In many ways the tax system systematically discriminates against lower middle income people.

A family of four making under about $30,000 pays little income tax and receives benefits from GST and child tax credits, so the tax system is pretty good to those people.

But god help the family earning between about $30,000 and $50,000. They begin to enter the higher tax brackets (particularly where only one parent or spouse works). But much worse, they also begin to lose child tax and GST benefits. As a result, they face high marginal income tax rates. In a real example, a family with two children earning $32,000 in 2001 with a single income pays $1986 in income taxes and collects $3553 in child tax credit and GST rebate.  But if they earn an extra $1000 they pay $152 more in taxes (only 15.2%). But they also lose $225 in child tax benefits and $50 in GST rebate. Their total incremental tax bill rises by $427, or a shocking 42.7%. In this case they are losing credits rather than actually paying in, but the point is they face a marginal tax rate of 42.7%.

Meanwhile an Albertan making $65,000 faces a marginal income tax rate of 32% (I was a bit shocked it was quite that low but that is what my tax program says – taxes were recently reduced in Alberta). Even at $100,000 my tax program shows a marginal tax rate of 36% in Alberta. So here we have a struggling family that is eligible for tax credits and yet they face a marginal tax rate that is higher than those making $100,000. This is shocking and outrageous, notwithstanding that the higher income person does pay a much higher average tax rate.

My complaint is that there is a hellish tax zone between about $30,000 and $50,000 where the incremental tax burden is huge and incentives to earn more money are minimal. If a spouse in this category takes a part-time job at $10.00 per hour, he or she ends up with $5.73 after considering income tax and losses of child tax and GST credits. And we must deduct an extra  63 cents for the employee’s share of CPP and EI, so that leaves $5.10. It might seem hardly worth working but then again this family probably needs the money so bad that they are forced to work extra, notwithstanding the approximate 50% total marginal total “taxation”..

Income Tax Police:

I earn a salary and I also have had tax losses from revenue property in most of the last 13 years and business losses in some years. Guess what?, I was not ever required to submit any receipts, I just claimed interest and expenses and the government has never once challenged or checked any of it. It would be so incredibly easy for me to under-state revenue or over-state expenses that I sometimes wonder why I don’t. So, apparently the income tax police don’t bother with people with good incomes and revenue property and even business losses.

Guess what happened when my wife started claiming day care receipts? You don’t have to enclose them with your return. But guess what, most years revenue Canada sends a letter and we have to send them in. So it seems to me that the income tax police spend their time chasing after day care receipts.

Income earners with losses on revenue properties and business losses are left alone in favor of chasing those with (usually) lower incomes who claim day-care expenses. I guess that’s to be expected since the power brokers in this country are more likely not the people claiming the day care expenses.

Nortel and Share Dilution Nonsense:

Long time members know that I have often used Nortel as a whipping boy example of incompetent management and extreme management greed. I rather despise this company. I first introduced Nortel on the Site as a Sell in December 1999 at $72.28 (adjusted for a subsequent split). I must admit that after it first doubled and then fell back to $70 I started calling it a speculative weak buy and eventually a speculative buy at $30. I finally got wise again and called it a sell in November 2001 at $9.04 and sold the shares I had bought at around $30 in complete disgust.

But, with the stock now at $2.49 there may come a point where it offers value.

This week the market was upset by the issuance of 550 million shares and also a commitment to issuing 422 million shares in three years by selling a convertible debenture.

The market was upset because the extra shares are potentially dilutive to future earnings. (That assumes that will be some future earnings.)

But consider, Nortel’s latest balance sheet showed an equity of $3.99 billion U.S. and 3.216 billion shares outstanding, for a book value of U.S. $1.24 per share. (And if you deduct the remaining $2.8 billion in goodwill and $1.8 billion in potential available income tax losses that may never be realized, you find that tangible book value is negative.)

Last week’s shares would have gone out at possibly over U.S. $2.00 But upset investors drove the stock price down and the issue went out at U.S. $1.41.

Here’s the deal. On a book value basis, this is immediately anti-dilutive (accretive) to book value and the dilution to earnings is only a possibility, they got $1.41 per share when the book value was only $1.24 (and tangible book value was negative). It’s completely normal for share issues to be anti-dilutive on a book value basis. Usually the issuing company has earnings and the new shares are usually dilutive to earnings in that they drive down earnings per share at least temporarily. So these shares will be dilutive to Nortel earnings if the company ever makes earnings again, but right now that is not in sight. Meanwhile the share issue has put U.S. $714 million of cash in the bank. This starts to put a platform of value under the shares. This cash makes it less likely that Nortel will eventually go bankrupt. As I see it this is a very good thing for existing shareholders.

Think about it. The market is now howling because Nortel issues shares for cash. But in 2000 when they issued shares for what proved to be near worthless acquisitions the market cheered wildly. Sure $1.41 per share is low, but it’s actually at least $1.41 better than issuing shares for some worthless money losing acquisition, as it now appears they so often did in the past.

The bottom line, I don’t know if Nortel is worth looking at yet, certainly much the same idiots are in charge so that gives cause for pause. But, if it’s not to ultimately go bankrupt then we must be getting close to the point where these shares become a buy. Consider that the market capitalization is now around 3.765 times CAN $2.49 = $9.37 billion Canadian which is arguably not a lot of money given the size and potential of the company.

Consider this too, if Nortel shares go back to $10.00 then investors who bought yesterday will realize just over a 300% gain. I’m not saying that will happen, but it is not inconceivable over the next 2 years. Now consider that when everybody was so excited about Nortel when it was at $120 and well over $300 billion in market capitalization, it was almost a mathematical impossibility that it was ever going to go up by a further 300% in anything like a 2 year period.

Markets are clearly prone to fits of irrationality at both the high and the low extremes of valuation. My quest is to find the irrationally low points. I expect to re-visit my Nortel analysis soon.

Next Issue:

I will summarize the key conclusions from an excellent book titled, What Works On Wall Street. This book was recommended by Warren Buffett.