Morningstar Magazine - December 2017/January 2018 - 15

The Breakup Plan: Indexers

Posner makes an immodest proposal, from
Jack Bogle's perspective: Break up the giant index
funds. "Big institutional investors would be
allowed to own only one firm per industry." Smaller
institutional investors, defined as those with
less than a 1% market share, would be permitted
to own more, but the giants would not.
Such an action would ban the index fund as
we know it, if it came from Vanguard, BlackRock,
or State Street. Such an "index" fund would
need to operate by sampling, limiting itself to one
issue per industry. Posner points out, accurately,
that such an approach preserves most
diversification benefits. (Indeed, sampling
is a common practice with fixed-income and
international-stock indexes.)
Bogle, unsurprisingly, is not amused. In addition
to disputing the argument that indexers enable
corporate misbehavior, he points out the
practical difficulties in enforcing such a ban. First,
there would be tax consequences for investors
in the existing index funds that would need to
unwind positions to conform to such a regulation.
Second, who gets Amazon.com AMZN? Or Apple
AAPL? Imagine running an index fund when
you weren't permitted to own the year's single
best-performing stock-but your rival was.
Szapiro doesn't see any such regulation occurring
under the current Washington administration.
However, he believes that the Democrats could,
conceivably, include dismantling the index giants
as part of a populist platform during the next
election cycle. There would be resistance because
middle-class investors benefit from the low costs
of indexing, but the possibility exists.
The Breakup Plan: Companies

Another way to reduce corporate profitability
could come from the executive branch. Posner
argues that the U.S. pendulum swings from high
vigilance when enforcing antitrust laws to
low vigilance, and that the United States currently
is near the low point. On that ground, he
has much support. Investment manager Jeremy
Grantham has written similarly, as have other
investment professionals. Using antitrust statutes
to disassemble companies and industries

is neither novel nor radical; it has a mainstream
U.S. history, dating back to Teddy Roosevelt.
Once again, such actions are unlikely over the near
term. Neither the Trump administration nor the
Republican-dominated Congress shows any
inclination to litigate against multinational firms.
For Democrats, however, taking on corporate
behemoths would be less problematic than
attacking index funds. Such activity is likely should
the Democrats regain control in Washington.

The Dividend Discount
Model Despite its
shortcomings, it still
has value.
THE OLD SQUIRREL

Ralph Wanger
Corralling the Chiefs

In addition to Posner's two suggestions involving
index funds and antitrust provisions, there
is a third option: Going after CEOs. Such an
approach has the advantage of directness. After
all, according to Posner's own logic, the
reason that corporations now have abnormally
high profits-and consumers abnormally poor
conditions-is because of choices that corporate
managements make. They may be aided
and abetted by index funds, and by a complacent
federal government, but ultimately the crime
is committed by the CEOs.
Want to stop a leak? Plug the source.
Here is my thought. Corporate chiefs are currently
rewarded for profitability, as manifested
by stock-price performance. So, change the rules
on compensation. Require that CEOs be rewarded
instead for growing their companies' market
shares. Or, perhaps, they should be paid
on relative rather than absolute stock-market gains,
such that if a company's stock rose 30%
on the year, and the industry average was 35%,
the CEO goes unrewarded.
Such ideas, obviously, need refinement. But the
point remains. It may be that index funds
have failed at corporate governance, and it may
be that because of this failure their power
should be removed. However, the case against
indexing has not yet been made, and even
if restitution is ultimately called for, it need not
necessarily lead to the restructuring of
index funds. K
John Rekenthaler is vice president of research
with Morningstar Research Services.

The classic way to value a company is the dividend
discount model, or DDM. The first serious
model was invented by John Burr Williams in 1938
in The Theory of Investment Value. He started
from the premise that serious investing was done
in the bond market. The value of a bond
was determined by the present value of all the
coupon interest that would be received
over the life of the bond, plus the present value of
the principal repayment at maturity. Doing
the arithmetic in 1938 was somewhat laborious,
but tables had been compiled, making it easy
to look up the answer.
Williams argued that the value of a common
stock was the present value of all the dividends
that an investor would receive in the future.
A stock does not have a maturity date, so one
doesn't have to worry about principal repayment.
One does have to consider the difference in payout
stream, because bonds pay a constant coupon
for a known number of years, and common
stocks pay a dividend stream that can go up
or down in the next year. Furthermore, the length
of that dividend stream is unlimited.
Winter Zombies

From today's perspective, it is generally believed
that company earnings, and therefore dividends,
will be in a continuing uptrend reflecting
the growth in the economy and most businesses.
That would not have been obvious to an
analyst in 1938. The economy of the United States
and of the rest of the world evolved rapidly
in the 40 years that Williams would have
considered, but there was no great evidence
of steady growth.

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