What's driving the trend towards intangible value?

The trend for the market values of firms to increasingly diverge from book value, and particularly from tangible book value, is really striking. As I wrote in my previous post on inflation, this is a trend that merits more attention.

So I was happy when I saw Justin Fox's piece for Bloomberg bringing more attention to this pattern. He presents an updated chart using data from Ocean Tomo (which I reproduce here from the original source)

Here's an older chart which also breaks out tangibles (gray) as well as the subset of intangibles that are on the books (brown, mostly goodwill):

It is important to understand exactly what the charts are showing. "Intangible assets" on the first chart is just a residual, the part of aggregate market capitalization that is in excess of aggregate tangible book value. (This is the red plus the brown on the second chart). It seems investors are increasingly willing to pay a lot more for a firm than would seem justified just by looking at the tangible "stuff" on the firm's balance sheet (including property-plant-equipment, inventories, and net financial assets including cash.)

I liked Fox's piece, but I wish his focus had been a little broader. "Most of their value," he writes, "comes from brands, patents, ideas and other intangibles....the modern corporation really is a different, much less bricky-and-mortary creature than its predecessors." Reading this, one thinks of firms like Google and Facebook, that have a lot of valuable software but only a relative handful of highly-skilled employees.

But it's too narrow to think about this just in terms of R&D and intellectual property and "ideas". Other important intangibles are scale, existing relationships with customers and suppliers, and "organizational capital," i.e. the value of having in place a large organization of skilled and trained employees with established procedures.

 In fact, by the measure shown in the figures, Google and Facebook are far from the most "intangible" corporations in the S&P500. Both have positive tangible book value. This would still be true even if you removed their cash.

By contrast, there are over 100 firms in the S&P 500 that have negative tangible book value. In other words, by the measure presented here, more than 100% of their market value is "intangible." The most strongly negative firms tend to be communications companies like Verizon or Time Warner Cable. But there are all sorts of firms on the list. A big part of this is that some firms have a lot of debt, but there is more going on here as well. (Interestingly, financial firms tend to be the most "tangible" by this measure.)

The case of United Rentals

Lets look at one of these negative book value firms: United Rentals (URI). With a market cap of around $9 billion, it is one of the smaller firms in the S&P500, having been added to the index in 2014.

United Rental's business is to rent out heavy equipment and other tools. Customers  include "construction and industrial companies, manufacturers, utilities, municipalities, homeowners, government entities." As of 2014, URI had 881 rental locations in the US and Canada, all filled with big expensive machines available for rent. The firm owns over $6 billion of property-plant-and equipment (about $60 per share). It has over 12,000 employees, more than Facebook. It would seem this firm is very, very brick-and-mortary indeed.

URI stock currently sells for about $90 per share. They are profitable, with a reasonable P/E of 17.5. But they also have over $80 per share of debt, and a tangible book value of equity of approximately negative $25 per share.

All in all, the tangible assets on their balance sheet are worth $2.6 billion less than their liabilities. Why is their stock worth 9 billion dollars? Why is anyone willing to lend them money (which they then use to repurchase their seemingly overpriced shares)? Where does the extra firm value come from?

The 2014 annual report gives an answer in the form of a list of "competitive advantages":

• Large and diverse rental fleet
• Significant purchasing power
• National account program (i.e. relationships with large customers)
• Operating Efficiencies. (i.e. "Equipment Sharing Among Branches," "Customer Care Center," and "Consolidation of Common Functions.")
• Strong Brand Recognition. 
• Geographic and Customer Diversity. 
• Strong and Motivated Branch Management. 
• Employee Training Programs. 
• Risk Management and Safety Programs. 

You could summarize these advantages as "scale" and "organizational capital." (There is some notion of "brand" there as well, although I doubt that a large customer really cares about "brand" in the same way a 13-year old cares about Under Armour, so maybe "reputation" would be a better word.)

Of course scale and organizational capital are not new. But the evidence suggests they may be more important than ever. Why? Perhaps information technology and increased regulation are factors that favor scale. Perhaps the relative decline in the price of manufactured goods relative to wages has inevitably made tangible goods a smaller portion of firm value. Perhaps the workforce (or a portion thereof) is more skilled, but effectively using these skills requires building complex organizations, with a large element of learning by doing.

I don't know the answer, but it's certainly an interesting question.

Are earnings yields real or nominal? How Inflation can affect the measurement of accounting earnings

This post is inspired by a twitter conversation I participated in last month that started when pseudonymous blogger/tweeter/super-valuation-expert Jesse Livermore posed an interesting question:

At issue is whether stock earnings yields should be considered real or nominal.[1] We all know that with bonds we need to inflation-adjust the nominal yield to find the real yield. But do we need to do any sort of inflation adjustment for earnings?

Jesse Livermore’s answer is no, and this seems to be the default assumption. In an ideal world, accounting earnings would measure sustainable real economic income, and would not have to be adjusted for inflation. The common practice of comparing earnings-based measures of valuation between eras with very different inflation rates relies on the assumption that accounting earnings are real and not nominal. (Note that the inflation adjustments used in calculating the Shiller CAPE do not address the issues treated here.)[2]

But I don't think inflation can ignored so easily; as I will explain, inflation can cause a “distortion” (for want of a better term) in earnings measurement. Furthermore, I will explain how we can attempt to approximately quantify this distortion, for a firm or for a market, using the following earnings adjustment equation:

Inflation adjusted earnings ≈ reported earnings – inflation * book value of tangible equity (t-1)

The basic idea (as discussed in detail below) is quite simple: the nominal value of items on a firm's balance sheet will tend to increase over time just to keep pace with inflation. This purely nominal increase will be reflected as net income, due to the clean-surplus nature of accounting. This causes earnings to be overstated relative to a situation with no inflation.

The adjustment does not require that the book value perfectly measure the true value of the firm. For example, assets are carried at historical cost. Still, if the firm has a relatively stable business model, such that the fraction of true firm value that appears on the balance sheet is constant, then the balance sheet will tend to grow along with inflation, resulting in a portion of reported net income that is purely nominal.

If we take the earnings adjustment equation and divide through by the market value of equity, (and ignore the “t-1” lag), we get the yield adjustment equation:

adjusted earnings yield ≈ reported yield – inflation * tangible-book-to-market ratio

In the US market today, inflation is low, and most firms (especially non-financial firms) have tangible-book-to-market ratios much closer to zero than one, so the adjustment is fairly negligible. But this has not always been true in other times and places. In the 1970s, inflation was above 5% and tangible book to market ratios were well over 50%, implying that inflation could have a meaningful distortionary effect on earnings yields. I suspect this may be an important factor underlying the seemingly low valuations and slow earnings growth in the US market in the 1970s and 1980s.

I will now walk through three highly simplified examples to show how the inflation distortion occurs, then discuss some complicating factors and briefly discuss the implications for valuation. [3]

Example: All Cash

Start with the simplest possible example. A firm starts the period with no liabilities, and only one asset: $100 in cold hard cash. Thus the firm also has $100 of shareholder equity, all of which is “tangible.” Assume the firm conducts some business during the period, resulting in $X in total sales, and $X-10 in total cost of sales plus all other expenses. The income statement is:

Sales                                                                X

Cost of Sales + Other Expenses                 X-10

Net Income                                                     10

Accounting profit for the period is $10. Assume no dividends, stock issues or buybacks, borrowing, or lending. Then at the end of the year the firm again has only one asset, $110 in cash. Likewise shareholder equity has increased to $110, with a $10 increase in the retained earnings account balance.

Now assume we are told that inflation over the period was 10%. Then the $110 cash the firm has at the end of the period is worth exactly the same as the $100 in cash it started with. The $10 gain was purely nominal, real gains were zero. There are no economic profits.

Note that we do not have to worry about the details of the business, how inflation affected each individual transaction that went into X, or even how large X is. Instead we can simply focus on the balance sheet. The principle of clean surplus accounting tells us that net income over a period is equal to the change in the value of shareholder's equity over the period, assuming for simplicity (and without loss of generality) that there are no other transactions with shareholders (i.e. no dividends or stock issues/buybacks.)[4]

In this example, the increase in the value of equity and hence also net income, was a purely nominal increase. If we use the earnings adjustment equation, we see that inflation-adjusted profits were zero:

0$ = $10 – 10% * $100

Example: Inventories

Imagine a retailer that sells widgets. At the beginning of the period they have an inventory of 100 widgets that they purchased wholesale at $1/widget. Assume there are no other assets or liabilities, so the balance sheet just shows $100 in inventories, balanced by $100 in equity. During the period they sell all 100 widgets for $150 total, incurring $40 of expenses along the way (wages, overhead, etc.). At the end of the period, they buy 100 new widgets to restock their inventory. Assume inflation is a uniform 10%, so the new widgets cost $110. The income statement is:

                Sales                                                   150

                Cost of Sales                                      100

                Other Expenses                                    40

                Net Income                                           10

Observe that the firm is now in exactly the same economic position as before, with 100 widgets and no cash. They have shown net income of $10, and the inventory asset and retained earnings equity accounts on the balance sheet have each increased by $10. But there is nothing left over to pay to shareholders, and no real economic earnings.

Note that if inflation is uniform and affects all goods and services at the same rate, the firm could go on like this forever, with each line on the income statement and balance sheet growing at the rate of inflation, showing positive earnings period after period, but never generating any real increase in value or providing any payouts to shareholders.

The inflation adjustment equation looks exactly like the adjustment in the previous example:

                                0$ = $10 – 10% * $100

An important assumption here is that the inventory is carried on the books at replacement cost. Under US GAAP (but not IFRS), many firms instead use LIFO (last-in-first-out) accounting for inventory. This creates a so-called “LIFO reserve,” which makes current profits lower and more accurate in real terms, but makes the balance sheet less accurate. This effectively pushes the inflation distortion out into the future, creating artificially higher accounting earnings in the future periods when the LIFO reserve is eventually liquidated. This is an example of how inflation in one period can distort earnings in subsequent periods (the next example using capital goods will show another way this can happen.) Nevertheless, even with LIFO accounting, if the firm (or market) is in a steady state where the LIFO reserve is not growing as a percentage of firm value, the earnings adjustment equation would still work.

Example: Capital Goods

Now consider a firm that rents out trucks. Assume the only asset is a fleet of trucks, and there are no liabilities. The firm operates in a steady state, where every year the company buys exactly one new truck, and disposes of its oldest truck. Furthermore assume that the trucks are carried on the balance sheet at historical cost, depreciated straight-line over 5 years, and that inflation has caused the price of trucks (and everything else) to increase steadily for several years at a constant rate of 10%.  At the beginning of the period the firm has just purchased a new truck for $50,000. The asset and accumulated depreciation balances for the "fleet-of-trucks" asset would be derived as follows:

		BOOK VALUE
Truck Age	Historical Cost	Begin Period	End Period	Depreciation expense
4	34,151	6,830	-	6,830
3	37,566	15,026	7,513	7,513
2	41,322	24,793	16,529	8,264
1	45,455	36,364	27,273	9,091
0	50,000	50,000	40,000	10,000
Totals	`	133,013	91,315	41,699

Assume that the firm derives $100,000 in revenues from renting out its trucks during the year, and incurs other cash expenses totaling $45,000. Then the income statement is:

Sales                                                      100,000

Depreciation Expense                             41,699

Other Expenses                                       45,000

Net Income                                              13,301

At the end of the year, the firm has $55,000 in cash (sales minus cash expenses): just enough to buy a new truck at the new 10% higher price! Thus the firm is once again left in the same economic position as before it started, with the same number of trucks of the same ages, and no cash. Once again there is no economic profit, despite the reported net income of $13,301. Once again the inflation adjustment is equal to the inflation rate multiplied by the book value of equity at the beginning of the year.

                                0$ = $13,301 – 10% * $133,013

Note this does not depend on the depreciation schedule accurately representing economic depreciation, and the truck asset does not need to accurately measure the value of trucks. For example, the trucks may last for more than 5 years. But none of that matters for the inflation adjustment - all that matters is that the “trucks” asset on the balance sheet has the same relation to true truck value over time, implying that the “trucks” asset needs to grow at the rate of inflation just to keep the real value of trucks constant. 

Discussion

In the interest of simplicity, the previous examples assumed that real profits were zero, and there were no payouts to shareholders. We could easily modify the examples to relax these assumptions without changing the basic lesson.

I have focused on the balance sheet approach, because it seems simpler. But we can also describe these distortions in terms of items on the income statement. In the widgets example, the cost of sales is effectively understated, because it uses the historical cost of widgets rather than the replacement cost when the widget is sold. In the trucks example, the depreciation expense is understated relative to the case of no inflation since the depreciation is calculated based on percent of historical cost, rather than on current cost.

Liabilities

For simplicity, these examples have also ignored liabilities. Liabilities on the balance sheet act much like cash in the first example, except with the sign reversed. In a steady state, if the balance sheet is to grow with inflation, liabilities will also grow, but this growth in nominal liabilities makes reported earnings lower rather than higher. This is why the inflation adjustment is based on equity (assets minus liabilities), rather than assets.

One issue I ignore here is the one-time gains or losses in financial assets and liabilities that will result when inflation shifts unexpectedly. Also ignored is whether/how these gains or losses are marked-to-market on the balance sheet. I suspect that these complications mostly have the effect of shifting earnings between periods, rather than creating permanent distortions in earnings.

Changing vs Stable Inflation

The examples above assumed that inflation was stable over time, which greatly simplifies the analysis. In particular, when the firm has multi-period capital investments, the distortionary effect of inflation on earnings in one period is not confined to that period, but will play out over several subsequent periods.

Consider again the trucks example. Imagine that instead of constant inflation, we had a one-time increase in prices, with no inflation in other years. After this burst of inflation, the "trucks" asset balance would continue to increase each year for a period of five years, until the historical cost of all of the trucks still on the balance sheet caught up to the new post-inflation price of trucks. Thus each year earnings would be overstated until the nominal value of the "trucks" asset reached a new steady state.

This shows that if inflation is volatile rather than constant, the adjustment becomes more complicated. To use the earnings adjustment equation, the current inflation rate would need to be replaced with some weighted average of current and past inflation.

Intangibles

Much of the value of a modern corporation arises from things that do not appear on the balance sheet. These “intangibles” include things such as brands, organizational capital, relationships with customers and suppliers, trade secrets, accumulated R&D, etc.  The distortionary effect of inflation on earnings is driven entirely by growth in assets that are recorded on the balance sheet, because their nominal balance sheet value must grow over time to keep up with inflation (as described in the examples above). Although intangibles usually require investments to maintain their value, these investments are generally expensed immediately, and thus do not show up on the balance sheet at all.   Hence off-balance sheet assets, such as many intangibles, will be irrelevant for the inflation adjustment.

There is a subset of intangibles, however, that do appear on balance sheets (the majority of which is goodwill).  As with other intangibles, any investments needed to maintain theses assets will not show up on the balance sheet.  Thus my assumption is that on-balance-sheet intangibles do not need to grow in order to keep up with inflation. This is why the adjustment equation uses tangible book value rather than total book value.  

Note that even though intangibles may reflect a failure of accounting to fully reflect the value of the firm, this does not invalidate the inflation adjustment equation. It is still the case that the tangible equity portion of the balance sheet will tend to grow to keep up with inflation. 

Relative Prices

A big assumption in this analysis has been that inflation is uniform across all goods. This is, of course, not true in the real world. In particular the cost of manufactured goods has generally fallen relative to other goods and services, and this has surely had some effect on firm balance sheets. This raises the issue of which inflation measure to use, and more generally how to account for relative price changes. I will explain why we should use the overall inflation rate, rather than the price change that applies to the particular assets of the firm.

In a competitive market, anticipated changes in relative prices should not affect the real return on investment. For example, imagine the nominal price of trucks stays constant while overall prices rise. Because of competition, you would expect that this fall in relative price would be passed on to consumers in lower rental fees, such that the real effective return on investment remained constant. The lower relative price of trucks indicates they are actually worth less in real economic terms, and that the firm is likewise less valuable. The lower real value of the "trucks" asset would represent a real economic loss, but this loss is not reflected in accounting income.

In the real world, things might be a somewhat more complicated. First, changes in relative prices that are not anticipated might be expected to change the return on sunk investments, at least in the short term. But this effect can go either direction and should tend to cancel out over time.

Over the longer term, the fall in the relative price of manufactured goods would lead to an increase in the value of intangibles relative to tangibles. In fact the US market has seen a very strong trend in this direction, measured in terms of the share of market value that is captured by tangible book value (see figure 1). (The decline in the relative price of manufactured goods are likely just one factor underlying this trend. Other factors could include changes in technology, industry mix, accounting rules, etc.).

Figure 1

Source: http://www.oceantomo.com/2013/12/09/Intangible-Asset-Market-Value-Study-Release/

This is a really striking trend that might well have important implications for earnings measurement, and whether/how earnings yields can be compared across time. It probably merits more attention than I can give it here.

On the other hand, the factors causing this shift, including changes in relative prices, have been evolving for decades, and there is no particular reason to believe the trends were any stronger in the high-inflation 1970s than the low-inflation 1990s. The inflation adjustment discussed here should be taken as an adjustment for the overall inflation that is orthogonal to changes in relative prices. 

Other Accounting Distortions

The inflation adjustment here does not require that book value perfectly measure the value of the firm. Likewise, it does not require that accounting earnings perfectly measure economic earnings, if the purpose is to compare valuations over different times or places. For example, perhaps you believe that (for some reason) accounting earnings in the US market consistently overstate true economic earnings. The analysis here merely suggests that they were even more overstated in high inflation periods than in low inflation periods, and that this should be taken into account when doing comparisons.

A similar argument can be made for changes in distortions. There may be reasons to believe that accounting earnings today need to be adjusted for reasons other than inflation in order to make them comparable to earnings in the past. The inflation adjustment discussed here is simply in addition to any other such adjustments.

Implications for valuations

In the US market today, inflation is below 2% and the tangible-book-to-market ratio is below 20% (see figure 1). Therefore the inflation adjustment for the earnings yield will be small, perhaps on the order of 25 basis points. However, the situation was very different in past decades. In the 1970s, general inflation averaged over 5%, and the aggregate tangible-book-to-market ratio was something like 80%. Therefore the yield adjustment equation would suggest we should adjust earnings yields in the 1970s down by as much as 4 percentage points in order to make them comparable to current yields. This would correspond to a shift in the P/E ratio from 10 all the way up to 16.7. I would not be surprised if this is an important factor explaining both the low valuations and slow real earnings growth in the US market in the 1970s and early 1980s.

I don’t know much about emerging markets, but it would not surprise me if inflation might cause earnings yields to be misleading there as well. Proceed with caution.

Comments welcome.

---

[1] The earnings yield is the reciprocal of the price earnings ratio. We should expect a relationship between the real earnings yield and the long run rate of return, as explained in this wonderful note from Brad DeLong. 

[2]   To calculate CAPE (Cyclically Adjusted PE ratio), Shiller adjusts the price and earnings series to constant dollars, in order to allow combining earnings from different years to create a moving average used to smooth the earnings series. However this does not correct for any bias created in earnings measurement within a single period, which is the issue addressed here.

[3] The basic ideas here are not new. They were well known in earlier high inflation decades, but seem to have been mostly forgotten. However the simple earnings adjustment equations and the application to understanding historical valuations are not something I've seen before.

[4] Clean surplus accounting means that all changes in shareholder equity that do not result from transactions with shareholders (such as dividends, share repurchases or share offerings) are reflected in the income statement.” (See the link below). There are a few items for which clean surplus accounting does not apply, “most notably foreign currency translation adjustments and certain pension liability adjustments,” which are not included in net income, but instead are reported as part of “comprehensive income.” This are probably not too important for this analysis, and I will be ignore them.
 http://financial-education.com/2007/08/11/clean-surplus-accounting/

Teach For America - Statistical Insignificance Strikes Again

Once again, as with the Oregon Medicaid Experiment, a prominent study with a "statistically insignificant" result is being misinterpreted by almost everyone.

The headline in the Washington Post’s Wonkblog reads “Teachers in Teach for America aren’t any better than other teachers when it comes to kids’ test scores.” The piece reports on a new randomized evaluation comparing on the latest scaled-up cohort of TFA teachers with non-TFA teachers in the same schools. We are told the new study finds that students of TFA teachers don’t have any positive impact on student test scores compared to other teachers, and this this conflicts with earlier research finding that students of TFA teachers scored higher on math tests.

Of course, that’s not quite the study showed. And, of course, you have to go dive into the study itself to find out what is really going on, since the common practice seems to be that if a result doesn't reach the magical .05 p-value you don't bother to put the point estimate or confidence interval into the press release, or even into the executive summary.

Let’s focus on the differences in math scores. The new research found a point estimate of .05 standard deviations (SD) higher math scores for TFA teachers than for comparison teachers. The the standard error is .05 as well, so the 95% confidence interval is something like [-.05, .15].  By conventional standards we can’t rule out negative impacts as large as .05 SD, or positive impacts as large as .15 SD.

Is .05 SD a large difference? Is .15 SD? Well, it’s hard to say. I guess .05 seems kind of small. The study points out that this corresponds to a one-percentile point difference at the 30th percentile of a Normal distribution, (although I don't know how they got that, it seems like it should be closer to two percentile points. I guess there was some rounding). But anyway it's not nothing, and it's not as if we have a long list of other cheap, feasible methods lying around to allow us to get test score gains. 

The study does helpfully point out that the .12 SD impact they found in reading scores for younger children (which, by the way, was deemed statistically significant, contradicting the headline), corresponds to 1.3 extra months of learning gains. So maybe the estimates impact for math would correspond to an extra 2 or 3 weeks of learning gains, or at the high end as much as a month and a half, although the correspondence might be different for math than for reading. Anyway, not nothing. It might be interesting to know how these gains compare to other differences that have been found in research, such as the gains from teacher experience, or smaller classes. But the report doesn't address that.

As per usual, the study says little or nothing about what differences might be substantively important or achievable, and instead focuses almost completely on statistical significance. It does include this extremely important quote, the kind of thing that really should be part of the executive summary:

Statistical power. Our study had sufficient statistical power to detect moderate to large impacts on student achievement. Minimum detectable effects were 0.13 standard deviations for math and 0.14 standard deviations for reading. In other words, if TFA elementary school teachers truly improved student math achievement by at least 0.13 standard deviations (slightly below the 0.15 standard deviation impact estimate found by the prior elementary school study), there is high likelihood (80 percent) that our study would have found a statistically significant positive impact. 

Apparently the authors think 0.13 SD would constitute a “moderate” impact (how they came to this conclusion they don’t say). So it looks like in fact we can't rule out "moderate" impacts, let alone "small" impacts. In fact, we can’t even rule out the effect in this cohort being the same as the effect in the older cohort from previous research, which had been estimated at .15 SD. The idea that the findings here are at odds with the previous research does not have strong statistical support. As Andrew Gelman likes to remind us, “The difference between ‘significant’ and ‘not significant’ is not itself statistically significant”

But what really got to me was this quote from the report:

Our finding that TFA and comparison teachers were equally effective is robust to multiple sensitivity analyses.

No, you did not find that they were equally effective. In social science, the null hypothesis is never exactly true. It is not plausible that TFA teachers and other teachers are exactly equally effective. If you fail to reject the null, it means your sample size was not large enough. And by your own assessment, you weren't even able to statistically rule out "moderate" differences in effectiveness, let alone prove that the were exactly equally effective. 

What this quote really means is "we kept running regressions, but the sample size never got any larger."

Meanwhile, Jason Richwine at National Review attempts to draw a lesson about teacher training

The fact that TFA requires only a five-week crash course in pedagogy — rather than traditional teacher certification — is another reason to question the value of an education degree.

While I share his skepticism about the value of an education degree, this research can't really say anything about it.The TFA teachers are a highly selected group, with much more elite educational credentials. We can't really conclude anything from this research about the impact of education degrees on typical teachers.

Overall, if we get informally Bayesian, we should probably conclude that the TFA teachers are likely at least a bit more effective than typical experienced teachers in the schools studied. This is consistent with the previous research, as well as the consistent pattern of positive albeit statistically insignificant impacts found in the report.

But to know the overall impact of TFA on test student achievement, you should compare the TFA teachers to the hypothetical teachers that would have been hired in their absence. It seems very likely that this comparison would be even more favorable towards TFA teachers. Comparing TFA teachers to the average, experienced teacher is the kind of mistake a sabermetrician studying sports would never make.

Stock Performance in the Era of Shareholder Value: A response to Montier

This week James Montier of GMO released an interesting white paper that is a scathing critique of the idea of “shareholder value maximization” (SVM), the doctrine that corporate executives should focus above all else on maximizing returns for shareholders, and that they should be compensated with stock and/or options in order to give them proper incentives to do. He makes many points, but perhaps his central piece of evidence, what he terms the “prima facie case against SVM,” is that during the era of SVM returns to stockholders have been lower than in the previous period. He produces the following figure:

 The bars on the left show the annualized real (CPI adjusted) compound returns. Realized returns were very similar over the two eras. Montier then observes (correctly) that a significant portion of the returns in the second period are simply due to P/E multiple expansion, which “have nothing to do with the underlying return generation of companies, but rather reflect the price that the market is willing to put upon those returns.” That is, corporate executives shouldn't get credit just because stocks became more expensive overall---they should only get credit for dividends and earnings growth.

Montier attempts to adjust for valuation to recover “underlying performance”, producing the bars on the right of the figure.  He doesn't say exactly how he does this, but the most obvious way is to simply reduce the realized returns by a factor representing the growth in the Shiller CAPE between the beginning and the end of the period.[1] I used this method (and Robert Shiller’s data) to recreate Montier’s results, as shown in the first two rows of table 1. My results appear very close to the numbers from Montier’s figure. After the adjustment, performance in the SVM era looks much worse than in the previous era.

But this is where I believe Montier made a mistake: valuations don’t just matter at the beginning and end of the period, they matter in the middle too, because they determine the price at which dividends are reinvested. A big factor raising compound returns in the earlier era was that dividends could be reinvested at the much lower average valuations that existed over this era. A big factor lowering returns in the later era was that dividends were reinvested at much higher average valuations, (including those around the internet bubble).

If executives don’t deserve credit for a change in valuation between the beginning and end of the period, then they also don’t deserve credit (or blame) for the path of valuations during the period.

A better way to remove the valuation element would be to see what returns would have been if valuation had been constant over the entire period. I calculated the returns for the two eras, using earnings and dividends in each quarter as given, but assuming index prices changed such that the CAPE maintained a constant value of 18, (the average over the entire period). The result is shown in the third row of the table.

Table 1

	Era of Managerialism 1940 Q1 – 1989 Q4	Era of SVM 1990 Q1 – 2014 Q3
Realized Return (annualized compounded, dividends reinvested)	6.94%	6.81%
Return corrected for starting and ending valuation	6.77%	5.14%
Return corrected for valuation over entire period (CAPE=18)	5.55%	5.83%

Using this method reverses the conclusion: now, “underlying performance” in the era of shareholder value maximization actually looks somewhat better than in the Era of Managerialism.

One may wonder why multiples were so low in the last couple of decades of the earlier era? It may have something to do with the fact that, adjusted for inflation, index earnings showed virtually no growth over the latter half of this era, despite substantial retained earnings. While "underlying performance" was good in the 1940s and 1950s, it was particularly poor over the last couple of decades of the Era of Managerialism.

The following figure shows 5-year moving averages of index earnings, and earnings retained (after dividends, not accounting for repurchases), measured in 2010 dollars.

Whatever corporations were doing with their substantial retained earnings in these middle decades, it didn't translate into any per-share real earnings growth, and this didn't change until right around the time the SVM era started. There may be many possible reasons for this, but one factor might be that, before SVM, managers had little incentive not to waste money in empire building or other unprofitable projects, rather than simply returning cash to shareholders. Another possibility might be that in the era before stock buybacks (another thing widely disliked by critics of shareholder value), managers who were reluctant to raise dividends too quickly found it difficult to return cash to shareholders even when they had few attractive investment opportunities. 

This is far from an open and shut case, and there are many other criticisms and issues that could be examined. But based on the "underlying performance" of dividends and earnings, it appears that the shareholder value movement, far from being the “world’s dumbest idea,” has actually been fairly successful.

---

[1] In this counterfactual case, on the last day of 2014 Q3, the S&P500 suddenly falls from its value of 1972 down to 1335, thus returning the CAPE from 26.2 all the way down to the level of 17.6 that it had at the end of 1989. This knocks about 1.7% off the SVM era returns, as shown in the second row of table 1. A similar adjustment is done for the earlier era, but it makes much less difference since the CAPE was close to the same at the beginning and end of the period.

What if the Apple Store Workers Were The Worst Workers Around?

Matt Yglesias posted a useful piece with the title "Imagining A Better World: What If The Apple Store Were The Worst Job Around?"  He points out that jobs at the Apple Store, while low paying, are enough to get you out of poverty and are a lot better than what the least-well-off have now. "The really urgent question isn't why aren't Apple Store jobs better, but why are so many jobs worse than this?"

In so far as this piece is meant to blunt criticism of Apple, I agree. But I think it is also useful to point out that many workers lack the qualities that would ever allow them to work at the Apple Store. They are too slow, unattractive, personally unpleasant, etc. These people need jobs too, but in a free market they will always be paid less than Apple Store employees.

The Apple Store experience is largely about aesthetics. If you are honest with yourself you will realize that most people won't want to come to the Apple Store to be served by someone who is, say, obese and barely literate. People go to Apple Stores because they feel cool. If Apple can't find workers who are at least superficially appealing, they might as well shut the stores and sell their products at Target.

Yet, realistically, adjectives like obese or surly or barely literate describe literally tens of millions of Americans. These people need jobs too! Maybe some of these people can work at other retail jobs, and some can work as janitors, house cleaners, fast-food cooks, etc. But I think it's an open question how most of these people will be employed in the long run, as factory-type manufacturing employs fewer, and retail itself struggles to compete with online sales. Yglesias envisions a future with lots of nurses, massage therapists, and personal trainers. Maybe so, but these jobs require a minimum level of intelligence and personal appeal that is simply lacking for a huge number of less fortunate Americans.

Thoughts on Entitlement Programs for the Elderly

Here are some thoughts about entitlement programs, prompted by reading this piece in the WSJ by John Cogan. (Brought to my attention by RecessionCone.)

1. Social Security and Medicare are really separate issues.
• SS needs some changes, but it could be tweaked into solvency fairly easily (given the political will.) The shortfall is not projected grow explosively. (See here:
• Medicare, on the other hand, is projected to grow grow and grow, like The Blob, until it eats the entire economy.
2. So always remember that it is the growth of Medicare that is the big problem. We could absolutely "afford" to continue to pay for the care that Seniors receive now; it's the extra care they are supposed to get in the future that is the problem. We could even "afford" to have expenditures grow along with GDP.
3. The fact that Medicare is projected to grow and grow, and we are simply cursed to accept this, seems strange. There is much disagreement (as well as much misinformation) about what is causing this and what can be done about it. Unfortunately doing anything about it at all can be politically unpopular, as both Obama and Paul Ryan have found out. This is a really tricky problem, both as a policy problem and a political problem.
4. Social security is and has always been a transfer program, where the young transfer income to the elderly. It's not, and has never been, a funded savings program, like a private pension. People often seem confused about this.
5. Don't forget that in any system at all where there are retired people, it is the young who produce what the old consume. When you remember that, transfers from the young to old don't seem that outrageous. It's all a question of how we set things up to make those transfers, how big those transfers will be, and how those things affect overall efficiency and growth.
6. Some of Cogan's points seem off:
   • Talking about what we "cannot afford" can be misleading. Taxes could be a lot higher. That may or may not be a good thing, but it is not impossible.
   • Cogan seems to imply that it is somehow unfair that the people who put in $500K are getting $1M in benefits. But that is a pretty low rate of return. These people would have done much better buying long term treasury bonds, let alone investing in stocks.
   • Cogan goes on to say:

     But regardless of how much they have contributed, the hard reality is that the federal government has already spent it. No matter how deserving they are, it is younger generations of workers who have to come up with the money.

     But that is equally true of someone who is redeeming government bonds! I doubt Cogan would use this as a reason for the US to default on our debts.
   • Cogan seems to call for a system of private accounts, invested in stocks and bonds. I have grave reservations about such a system, which I will leave for another time.
7. Cogan is also right about some things
   • Cogan says the current system is "not the result of elected officials carefully weighing the needs of senior citizens against the financial ability of younger workers to meet these needs." That's right: it is the result of a political process. Like everything the governement does. Always a good thing to keep in mind.
   • He's right that reform is needed. His proposals for reform are not all what I would choose, but at least they are serious proposals.

The most important thing to me is that we need to get the long term fiscal picture in order, as soon as possible. This will require reductions in the growth of spending (sometimes misleadingly called "cuts") as well as tax increases.

Book Reviews - Stuart England

Mark Kishlansky, A Monarchy Transformed, Britain 1603-1714

T.B. Macaulay History of England, from the Accession of James II

Last month I resolved that I should consume less news and read more books. About this time I also got an android phone with Kindle software. So now that I'm reading more books, I thought I'd jot down some reviews, for myself and the 2 or 3 other people who might read this blog. Lately I've been reading mostly history.

Stuart England is a time and place that should be pretty interesting. You've got one King losing his head and another being driven out by his own daughter and son in law! Roundheads vs. Cavaliers! Oliver Cromwell and the New Model Army! Austere, moralizing puritans and other religious dissenters! Dissolute libertinism in the Restoration period! Pepys' London, the fire, and the plague! The beginnings of the enlightenment, with Newton, Bacon, Hooke, Hobbes, and Locke! Colonization of North America! The first Whigs and Tories, and the main foundations of constitutional monarchy!

Unfortunately, Kishlansky's book focuses almost exclusively on political history, so it just skips over a lot of the stuff I listed in the last paragraph. In hindsight, I would have liked more liked more social, cultural, and economic history (like I found in the much-more-enjoyable volume of European history I read last fall, The Pursuit of Glory.) I suppose it is difficult to cover such a long time period without making the reading sort of dry. Still, I found it dry even by these standards. It didn't even include the word "Roundhead!" Plus, the Kindle version didn't have the maps! Can't recommend.

Not satisfied that I'd gotten all I could get from this period of English history, I started reading Macaulay's famous history, downloaded for free from project Gutenberg. I read volume I and much of volume II (there are five volumes altogether). This is also mostly political history (except the justly famous Vol I chapter 3 which gives an overview of the state of technology in 1685), but the prose is much more lively, and everything and everyone seems much more interesting. Macaulay is criticized today for his "whiggish" approach to history, but his biases are easy to detect, and anyway probably aren't too different from my own. I liked it a lot. (I stopped after volume II, because I don't think I want to read three entire volumes about the exploits of William III.)

The most exciting parts were probably the account of the "Glorious Revolution" in the last two chapters of volume II. Even though it wasn't really a revolution, and the main principle at stake was the King James' refusal to sufficiently persecute Roman Catholics.

Favorite newly-learned historical fact: The secret treaty of Dover, in which Charles the second agrees to put himself and his armies at the service of Louis XIV, and even convert to catholicism (!!), all for a couple hundred thousand £'s.

Historical character I'd like to learn more about: Cromwell, Marlborough (tie)

Favorite obscure historical character: Praise-God Barebone (pictured)

Favorite historical hijinks: James II trying to flee England in disguise, getting captured by fisherman and treated rudely, but eventually recognized and returned to London. Nobody knew what to do with him, so they kind of let him escape again.

Favorite passage: taken from Macaulay's description of the character of Charles II, from Vol I, Chapter 2:

According to him [Charles], every person was to be bought: but some people haggled more about their price than others; and when this haggling was very obstinate and very skilful it was called by some fine name. The chief trick by which clever men kept up the price of their abilities was called integrity. The chief trick by which handsome women kept up the price of their beauty was called modesty. The love of God, the love of country, the love of family, the love of friends, were phrases of the same sort, delicate and convenient synonymes for the love of self. Thinking thus of mankind, Charles naturally cared very little what they thought of him. Honour and shame were scarcely more to him than light and darkness to the blind.

In Defense of Oil Speculators

Whenever oil and gasoline prices go up, people start vaguely casting blame on "manipulation" and "speculation." Now I see that even Obama has gotten into the game, vowing to"root out any cases of fraud or manipulation" in gasoline prices, "and that includes the role of traders and speculators [big applause line]."

It's true: speculation in oil futures can drive today's price up (or down). And that's just what we should want it to do.

Because we shouldn't care just about today's price, but about tomorrow's price too. If we knew that demand would likely be higher in the future (for example because of seasonal effects), or that supply would be lower in the future (for example because of unrest in oil producing countries), then what we would want to do is take some oil off the market today and save it for later. This would of course drive up the price we pay today, but it would lower the price we'd pay later when the oil would be even more scarce.

This is exactly what "speculators" try to do. People who believe they are well informed about future oil market conditions bid up futures prices, which causes people to store oil, or just leave it in the ground, in anticipation of higher prices later on. If these people are right, then they make money (at the expense of the people who took the other side of the bet), and consumers are better off in the long run. Of course the speculation could prove wrong (that's why it's called "speculation"), but still it represents the aggregated best guess of the people who have studied the issue enough that they are willing to place large bets on the outcome. If they are wrong, they lose money.

Now let's look at some quotes from the story about Obama's announcement as reported in McClatchy Newspapers:

Despite turmoil in the Middle East, there has been no significant interruption of oil production, and supplies remain abundant.

Well, not yet. Futures prices are about preparing for the future. Or would you prefer we just forget about the future and just burn whatever oil we can get our hands on with no concern about what might happen later?

Obama is under political pressure to address gasoline prices that are nearing an average of $4 a gallon.

Of course, political pressure. Ignorant voters forget that oil is traded in a world market and the president has basically no power to affect the price. Perhaps they would prefer that the government take over the entire gasoline market; maybe we could even have gasoline riots, like they do in Iran.

Commodities markets rely on speculation. It's excessive speculation that regulators are trying to curb.

Great! I'm sure government bureaucrats will just gaze into their federally issued crystal balls and determine when speculation is "excessive," outguessing the investors who make their living by making these predictions.

Bart Chilton, a member of the Commodity Futures Trading Commission, has argued that speculation is excessive.

Then maybe he should use his special insight sell some oil futures and get rich. Good luck with that, Bart!

But he said that determining how much of the oil-price increase stems from speculators, rather than a "fear premium" rising from Middle East instability, isn't a simple calculation.

Um, aren't these the same thing? The "fear premium" is due to a reasonable "fear" that supply will be lower in the future. (Of course if the fears turn out to be unfounded, then all those "speculators" will lose money. But predictions are hard, especially about the future.)

Proving market manipulation isn't easy.

Right, so this will probably come to nothing. (In fact, I don't think there are any commodity traders remotely big enough to "manipulate" this giant world market.) Maybe that's what Obama thinks too...I like to think he's smarter than this.

How I know Climate Science isn't "Unequivocal"

First, I believe that CO2 (among other gases) is increasing in the atmosphere due to human activity, and that this will have a first order effect of warming the planet. I also believe that we have seen moderate warming over the last century or so (indeed the warming started even before the CO2 really took off). But I don't believe that the evidence for predictions of large, catastrophic global warming is, as we are often told, "unequivocal." Here's how I know.

In 2009 I saw global warming alarmists on the internet gleefully pointing out this new study from MIT scientists, showing that "climate change could be double previous estimates. " Here's a quiz: should this make you more or less confident in global warming models? I'd say that if you just found that your previously unequivocal models might be off by a factor of 100%, you might want to rethink whether they are really so unequivocal or not. If they can be 3 degrees too low, maybe they can also be 3 degrees too high. (This isn't unique: here's something from 2005 predicting warming twice as bad as previously thought.) Instead, findings like this seem to only make climate alarmists more sure of themselves. And people were already saying these predictions were unequivocal back in 1996 when they didn't even know about something so important as the Pacific decadal oscillation yet.

I mean, these models are really, really complicated. They have lots of degrees of freedom. And I don't believe they have produced any very impressive out-of-sample predictions yet. Furthermore, I'm confident that all the funding and publication biases would run in the direction of people wanting to predict more warming. Scientists are unfortunately not immune to overconfidence and confirmation bias.

And when I read criticism of "deniers" and "skeptics," all the focus seems to be on the least informed straw man arguments that come from people like Rush Limbaugh. I never see anyone respond to skeptics like this guy.

So I don't discount the possibility that CO2 emissions might have large impact on climate. I think it is definitely something to worry about and study. Climate science is not a "scam," as many crazies on the right will tell you. But being told it is unequivocal really gets my BS detector going. Apparently expressing any skepticism about even the magnitude of effects is enough to get you kicked out of polite society. This is not healthy.

Waiting for Superman?

I missed a big twitterfight yesterday about the film Waiting for Superman. So I thought I'd put up a few of my many thoughts about school reform issues.

1. I haven't seen WFS. I agree that most popular documentaries are manipulative and should be taken with a large grain of salt.

2. As I tweeted before "good school" mostly means "good students."

2a. US schools aren't as bad as you think, it's the students that are bad. I believe outcomes for Chinese students here are much more similar to Chinese students in Singapore than they are to Chinese students in China.

2b. There is probably no magic bullet in school reform, and even things that are most worth doing will probably show small effects.

3. Disappointingly, research shows that charters overall haven't appeared to perform very well.

4. Nevertheless, there is a subset of charters that does appear to perform better. It would be nice to allow those charter models to expand. But there are many political obstacles to opening new charters.

5. Personally, I would like to see less power for unions of all kinds, and public sector unions especially. I think teachers are great, and I admit that unions help them get higher compensation and less mistreatment by employers, things which I fully support. But this is outweighed by the negative effects of unions: they block all chances for positive reform other than tinkering around the edges, they often protect the jobs of even very incompetent teachers, and they lobby for compensation structures (e.g. DB pensions, extra pay for master's degrees) that are bad for the system.

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