Morningstar Magazine - December 2017/January 2018 - 16

Dispatches

An analyst would have remembered the catastrophes of the Great War and the Depression of
1921, then the euphoria of the late 1920s, followed
by the Depression, when the ghosts of bankruptcy
and Bolshevism caused the same fear of the
future as when the White Walker zombie army
crashed through the Wall into a helpless Westeros
in Game of Thrones. The Dow Jones Industrial
Average was 100 in 1905 and 100 in 1942. So, the
idea of a buy-and-hold strategy would have
seemed preposterous to the handful of investors
who had not already been turned to zombies
in the dreaded winter of 1932.
There are several practical problems with the
Williams dividend discount model. First,
the present value of an income stream extended
far into the future is so hard to estimate
correctly that the present value calculation is
nearly meaningless. The math tends to
be dominated by events more than 10 years
in the future about which you and I know
nothing. If you think otherwise, find a collection
of the analyst reports that you and your
colleagues wrote 10 years ago.
Another blow to the DDM is the disappearance
of dividends, leaving nothing to discount or model.
In the early 1990s, corporate managements
made the agreeable discovery that the success of
their company was primarily due to the managerial
genius of themselves. Therefore, because
the increase in stock prices was created by these
managers, they were clearly undercompensated for the riches they were bestowing upon
their indolent shareholders.
The invention of stock options righted this wrong.
It allowed the management group to seize 4%
of the company every year, under the threat that
less compensation would cause them to transfer
their wealth-making power to a competitor.
In this model, dividends were a nuisance because
they were not factored into the option calculation.
Dividends were cut or eliminated, and the
money that would have gone to shareholders was
put into stock-repurchase programs. A large
stock-repurchase program would offset the stock

dilution caused by the stock-option program.
That way, at the end of the year, the company
would have the same number of shares
outstanding but with the managers owning more
and the shareholders owning less. This transfer
of wealth from owners to managers has
been remarkably easy. Shareholders never knew
what hit them.
Sell Signals

Despite the numerous shortcomings of the
dividend discount model, it has been useful in the
past and should continue to have value in the
future, probably by broadening the definition of
dividends to include stock repurchases.
I first used it as a theme of my senior thesis at
MIT in 1955. I took the Williams model of 1938 and
fiddled with it to account for senior securities
on the balance sheet and added a way to taper
future growth to adjust for the inevitable mean
reversion of a highly profitable company. There was
a new DDM in academia at that point, the
Gordon-Shapiro model, which led to the equation
p=d/(r-g).1 I was able to show that this was
formally the same as the Williams DDM.
When I started running a mutual fund in 1970, I
thought that a DDM would be useful in comparing
stocks in different industries, so I adopted a
model invented by U.S. Trust. At that time, U.S.
Trust was a leading institutional manager using the
same "Nifty 50" strategy as every other bank
in New York. By 1972, the model was throwing off
signals that stocks were wildly overpriced. The
terrible bear market of 1973-74 proved that the
DDM had given a valid signal. Everybody saw their
portfolios drop 50%.
In 1974, I called one of my buddies at U.S. Trust
to congratulate him on the success of the
firm's model forecast. My friend was not in a good
mood. He told me that the bank, seeing that the
model was generating sell signals, did the sensible
thing and scrapped the model. My buddy had
been fired and was just in his office to pack up the
kids' pictures and the golf trophy. (U.S. Trust
was acquired by Bank of America BAC in 2007.)

Future Value

The world has changed a lot since the 1960s. In
those days, most businesses were capitalintensive; to grow, they needed a high return
on equity. They could then pay out half the profits
in dividends and plow the other half into
expanding their factory. The clearest example
of this was the electric utility industry. The number
of kilowatt-hours used in the country grew at 7%
per year from 1912 to 1972. Utility companies,
therefore, had to continuously build new
generating capacity. State regulators allowed the
utilities a high rate of return on the new plant, so
that shareholders received a constantly increasing
dividend stream. Because the technology of
generating electricity improved steadily, utilities
were able to reduce the price of electricity to
consumers, delighting the public and the
regulatory agencies. 'Twas a veritable paradise
on earth.
The DDM was ideally suited to value electric
utility stocks, and I remember having earnest
discussions as to whether the long-term growth
of Commonwealth Edison would be 6% or
6.5%. Then in 1973, OPEC found that it had the
power to quadruple the price of oil, and the price
of coal and electricity soared as well. With higher
prices, the growth of utility usage went flat.
Beginning in 1990, electricity growth dropped
to zero. Utility companies went to their regulators
to have prices adjusted upward and were
surprised to find that the same regulators who had
been so cooperative approving price decreases
were no longer friendly at all. The DDM was
no longer useful in predicting utility stock prices.
So, the dividend discount model is not that useful,
because the future is too uncertain. But we already
know that. The DDM is still of value, solving for g,
the growth rate implied by the stock price. If the
implied growth rate is suspiciously high, you might
decide that you are assuming that a high return
on equity may be true now, but mean reversion will
spoil your longer-term euphoria. K
Ralph Wanger, CFA, ran Columbia Acorn Funds from 1970
to 2003.

1 Gordon, M.J. 1959. "Dividends, Earnings, and Stock Prices," The Review of Economics and Statistics, Vol. 41, No. 2, pp. 99-105. I did my work from Gordon's work at MIT in 1955.

16

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