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want cash now to compensate for risk. In The Great Crash, John Kenneth
Galbraith uses the word “bezzle” to describe an aspect of this mood
swing. Bezzle is derived from embezzle, and Galbraith describes the
ability of people to siphon funds out of companies and the world more
generally. In good times, investors (and perhaps regulators) are opti-
mistic and lax. Therefore the bezzle increases. In contrast, Galbraith
writes, “In [economic] depression, all this is reversed. Money is watched
with a narrow, suspicious eye. The man who handles it is assumed to be
dishonest until he proves himself otherwise. Audits are penetrating and
meticulous. Commercial morality is enormously improved. The bezzle
The overall pattern of optimism and pessimism is a recurring theme in
investments. When everyone is optimistic about stocks, they tend to be
worse investments. Doom and gloom generally predict good stock mar-
ket returns. These emotions get reflected in stock prices. Consider that
the S&P 500 investor today accepts about $1.81 in dividends and fore-
goes $4.40 in sure interest. Why accept a lower return? The lower return
today is accepted because investors are optimistic about the growth of
dividends. In other periods, stock investors have been so skeptical as to
require that dividends exceed bond interest.
In the modern market, such skepticism is reserved only for those com-
panies that are perceived as particularly risky. For example, a $100
investment today in Altria (formerly Phillip Morris) yields $5.50 in divi-
dends.11 An investor earns more today from Altria dividends than from
the interest on a 10-year Treasury bond. Because investors fear that
smoking-related lawsuits might bankrupt Altria, they price the stock so
that they are paid to take risk. While this skepticism exists for Altria, for
the market as a whole, investors are willing to accept lower dividends.
Currently, optimistic investors accept low dividend yields in the hopes
of future gains. Even without any change in stock market fundamentals,
any move that clamps down the bezzle and general optimism would be
reflected in lower stock prices.
Where do we stand on stock valuations? Based on the Fed model that
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compares stocks to 10-year Treasury bonds, stocks appear to be reason-
ably valued. Based purely on the Fed model, optimists can buy in the
hopes of strong profit growth and pessimists can sell on the expectation
of profit disappointments and interest rate rises. Beyond the Fed model,
however, valuations are dependent on growth rates and emotional swings.

Natural Limits to Earnings Growth

Some years ago, I watched Arnold Schwarzenegger being interviewed
about the appeal of bodybuilding. He was asked, why are some people
obsessed with physical size? Arnold replied, “You don™t go to the zoo to
see the mice.” His claim was that humans are naturally built to care about
size. (In Pumping Iron Arnold seeks to make his opponent Lou Ferrigno
feel bad about himself. Accordingly, he hits Lou with the worst insult
possible to a bodybuilder, “Lou, you™re looking very small today.”)
Stock market pundits are obsessed not only with the size of corporate
profits, but also with their growth rate. You can imagine investors in fast-
growing companies making Arnold-like comments of, “You don™t buy
stocks for their book value.” The obsession with growth is appropriate
given the fact that stocks are risky and pay less today than safe Treasury
bonds. The main reason to accept the risk of stock market losses is the
promise of a growing profit stream. Thus, investors are correctly
obsessed with growth.
What are the prospects for corporate profits growth? Here, there is a
clear answer. It is that profit growth, and consequently stock prices, can-
not continue their historical performance.
Before getting to the reasoning for the limits on profit growth, it is nice
to point out that this is one of the few questions that have an unambigu-
ous answer within the investing world. This rarity of clarity is the subject
of an entire subset of the jokes about economics (also known as the “dis-
mal science”). For example, if you laid all the economists in the world
end to end they still wouldn™t reach a conclusion. Or, more cruelly, if you
178 Applying Science and Art to Bonds, Stocks, and Real Estate

laid all the economists in the world end to end that would be a good thing.
To counter this, let™s make the clear statement and then explain the rea-
Fact: Corporate profits have been growing above their natural speed
limit for a long time. The future for stocks cannot be as bright as the past.
On the road to this conclusion we start at the basics”with bacteria.
Almost every biology textbook contains a section that describes bacter-
ial growth rates in terms of something like this: Some bacteria can
divide every two hours. If this replication pace were sustained for sev-
eral weeks, the offspring of one bacterium would weigh more than the
Continuing our Arnold theme, bacteria could mock Internet compa-
nies by saying, “Yahoo!, you™re growing very slowly today.” Left uncon-
strained, one bacterium would become 4,096 in one day, over 16 million
in two days, over 60 billion in 3 days, and enough to weigh more than the
earth in a couple of weeks.
So bacteria can grow really fast. Over the long run, what has been the
growth rate of bacteria? The surprising answer: zero. Bacteria have been
around for a really long time. Doing the simple mathematical calculation
of the annual growth rate over their history, bacterial growth rates are
infinitesimally greater than zero.
An unavoidable mathematical law causes the contrast between dou-
bling every two hours and a long-term growth rate of zero. At least for the
last several billion years, the earth itself has not changed significantly in
weight. The long-run rate of growth of the earth has therefore been zero.
Thus, anything that is a subset of the earth, including bacteria, must have
a long-run growth rate of no more than zero.
This is a mathematical truism. A part of a system cannot sustain a
higher growth rate than the system for an indefinite time.
Just as bacteria are part of the earth, any single company is part of the
global economy. Thus, over the long run, no company can grow faster
than the world™s economy. For example, Figure 8.5 shows the growth in
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Annual % growth

Microsoft (Revenue)
America (GDP)

* Estimates

FIGURE 8.5 Microsoft™s Growth Rate Has Slowed toward That of the U.S.
Sources: Microsoft, U.S. Department of Commerce, Congressional Budget Office

Microsoft™s revenues from its public d©but until today as compared with
the growth of the U.S. economy. (The best graph would use global econ-
omy growth; the chart uses the United States because the story is the
same and the U.S. statistics are more reliable.)
When Microsoft was a young company, its growth rate was spectacu-
lar. Over the years, however, that growth rate has slowed and now is
much closer to that of the entire country. Over the long run Microsoft
cannot grow faster than the economy. In fact, the gap is projected to dis-
appear in 2005 (Figure 8.5).12
Whenever a company, or a set of companies, is growing faster than the
economy, that growth rate is unsustainable. The relevant question is not
if growth will slow to the natural speed limit but when growth will slow.
Both corporate revenue and profits are subject to the same natural
speed limit. Neither revenue nor profits can grow faster than the economy
indefinitely. Figure 8.6 shows, however, that U.S. corporate profits have
been growing faster than the economy.
180 Applying Science and Art to Bonds, Stocks, and Real Estate

% growth, 1987-2004




America (GDP ) * Profits (U.S. firms)
* through mid 2004

FIGURE 8.6 Profits Have Grown More Than the Economy
Sources: Bureau of Economic Analysis, U.S. Dept. of Commerce, Congressional
Budget Office

Looking at the data from the same period as the Microsoft chart, U.S.
corporate profits grew faster than the economy. This growth in profits”
that is above the natural speed limit”is unsustainable. While there is no
obvious time for this above-average growth to end, it must eventually
end. The logic is as inescapable as death and taxes.

Buying the Hype at Precisely the Wrong Time

Profits of U.S. firms have been growing faster than the economy. What
does this imply for stock prices? When something is doing better than
average, it probably pays to be a bit cautious. If an athlete, for example,
has a fantastic year, it would be prudent to expect the next year to be less
As investors, it seems that we are built to feel exactly the opposite. We
tend to overweight recent events. This leads us to be most optimistic at
exactly the wrong time. Consider the case of Sun Microsystems. In the
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late 1990s Sun was riding a boom caused by Y2K and the Internet bub-
ble. Sun™s revenues and profits were shooting up at rates approaching
100% a year.13
What should a rational investor have done when evaluating Sun™s per-
formance in the late 1990s? The answer is that, rationally, 100% growth
rates are unsustainable. Thus, a prudent investor would have given a
lower weight to Sun™s current performance. Historically, investors have
priced stocks at somewhere between 10 and 20 times a firm™s current
profits. Prudence in the late 1990s might have argued that Sun deserved
something toward the low end of this range.
Did investors realize that Sun™s performance in the late 1990s was
unsustainable? Quite to the contrary, their lizard brains caused them to
bid Sun™s price stock up until they were paying close to 100 times current
earnings! Precisely at the moment when Sun™s profits were growing at
the most unsustainable pace, investors valued those profits at the highest
level. The result was financial devastation for Sun shareholders as the
stock lost more than 90% of its value.14
Figure 8.7 suggests a potential problem for stock prices. It shows that
stock prices have risen even more than corporate profits in the years
since 1987.
The diagram takes the most conservative estimate of stock market
appreciation. As a starting point, it takes the highest level of the Dow
Jones Industrial Average before the 1987 crash.15 Any other starting point
would yield an even higher growth rate. Furthermore, the calculation
ignores dividends, which would again serve to dramatically increase
stock market returns.
We end up with two layers of unsustainable growth. Corporate profits
are growing at an unsustainable pace relative to the economy, and the
stock market™s valuation of those profits is growing even faster. If profit
growth is going to slow toward its natural limit, then current profits might
be reasonably valued at prudent multiples. Quite to the contrary,
investors have bid up stock prices so that they are paying more now for
every dollar of profits than before.
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