International Forecaster Weekly

The Greater Fool

The greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants.

Bob Rinear | May 10, 2017

I continue to do a fair amount of radio interviews, and Tuesday I had the distinct pleasure of chatting with my friend and radio host Phil Mikan out of Connecticut. We were talking markets, manipulation, pensions, economy, etc, but there was one particular issue that I wanted to stress to his listeners.

Phil had mentioned that his own mom worked at a large insurance company and over the years she had invested into the company’s stock, and the company would also match her contribution with another share. Over the years, the combination of her own buying, along with the company donating shares, combined with the dividends the stock paid… created a nice supplement to her retirement.

Well there’s a sneaky word in there that you just don’t hear of like you did 20, 30, 40 years ago. Dividends. Now I’m sure most of you know what a dividend is, but just for “flow” let’s take a look.

A dividend is defined as a payment made by a corporation to its shareholders. Usually these payouts are made in cash (called “cash dividends”), but sometimes companies will also distribute stock dividends, whereby additional stock shares are distributed to shareholders

Okay, so let’s say you take a company like GM which is trading around 34 bucks. Well, they pay about 1.54 dollars on an annual basis, per share you might own. That’s about a 4.2% return on the price of the stock. Now consider if you had bought GM many years back, and over those years, you added to your holdings and maybe even used your dividends to buy more shares? You could have built up quite a nice jackpot.

In our example, if you owned 22 shares of GM stock, at the end of 4 quarters of dividends, you’d have enough money to buy an additional share. And yes that share would pay you a dividend. Let’s expand on that for a minute. Let’s suppose you took 10K dollars last year, and bought GM stock. You’d have about 294 shares. But, because each of those shares pays you 1.54 in dividends, you’d have “taken in” 452 bucks. Now you could save that money, or…you could go right in and buy another 13 shares of stock. Then you’d have 307 shares of stock, paying you 472 dollars for the year in dividends.

Do that over and over each year for 20 years and you can see, you’ve built a very nice nest egg. Many hundreds of thousands of folks have done just that over the years since WWII to create one heck of a nice contribution to their social security retirement. That my friends is investing with a purpose.

But then there’s the stocks with NO dividends. Hundreds of companies with names you know, pay no dividends at all. EBAY, Amazon, Google, DirecTV, Micron, F five, etc. etc. Enter the “greater fool theory”.

The greater fool theory states that the price of an object is determined not by its intrinsic value, but rather by irrational beliefs and expectations of market participants. A price can be justified by a rational buyer under the belief that another party is willing to pay an even higher price.

If you buy a stock with no dividend payment, then the only way you can realize a return on your money, is if you are able to sell it to someone else, for more money in the future. That’s it. You’re looking to get out with a profit and the buyer is looking to get in, and hopefully sell it even higher.

The question then of course becomes…why would you want to invest in a stock that pays no dividend? Well, your hope is that the company has decided that instead of distributing the profits to shareholders as dividends, it will reinvest that money into more growth of the core company. Then, as the company makes more and more money, more investors will buy it and the price will rise. But again…why?

Hope. Yes, it’s hope. The hope in buying a company that pays no dividends, is that it will grow and be so successful, that its “intrinsic” value is so great that there’s always the hope that they’ll come out with a one time enormous dividend payment.

Consider Berkshire. Buffet has only paid out ONE dividend in all these years. Yet in 1990 it was 5, 000 dollars per share, and today it is 245,000 dollars per share. Investors buy it “knowing” it holds intrinsic value because Berkshire owns airlines and shipping companies and rail lines, etc. Tens of billions worth of good reliable companies.

They have like 90 billion in cash. Every holder of Berkshire stock hopes that one day Buffet will take the wrong med’s and dole out a 50 thousand dollar per share dividend. Between the safety of its intrinsic holdings, and the “hope” of a one day one time divvy payout, investors love Berkshire. They simply don’t get paid for holding it.

The problem is that for every Berkshire, or Amazon, or google that doesn’t pay out earnings via dividends, is a thousand companies that don’t pay dividends, but don’t rise either. In other words, if you’re going to hold a company that doesn’t pay dividends, it had better have something going for it. A unique product, a barrier to entry, a management team from Heaven, the hottest thing since sliced bread…something to justify the idea that someone else might buy it from you at a higher price.

If you’re simply trading stocks for swings, none of this matters. Stocks go up and down and catching breakouts, double bottoms, pendant formations, all adds up to short term gains. But if you’re a “set it and forget it” sort of folk, I’d always err to the side of wanting to get paid to hold my position.

Look at Ford. It’s 11 bucks a share and pays out 60 cents a year in dividends. That’s 5%. That’s multiples higher than your local bank pays on deposits in CD’s. Ford shouldn’t go out of business. Yes it’s stock could go lower, but it probably won’t stop paying a dividend. That’s at least the type of long term investment I could agree with. A long standing company with a relatively low stock price and a 5% divvy. Not bad. But to buy the XYZ company that pays no dividends, is in a highly competitive field, and has shaky management? No thanks, I’ll trade it, but I won’t “set it and forget it”.

That would be the ultimate example of the Greater fool theory. Don’t go there.