There is an interesting debate over my column on Monday, which looked at evidence for distorted profits in the US. In brief, there is a long-term discrepancy between the earnings yield on the S&P 500 (the inverse of the price/earnings ratio), and the long-term actual real return to investors (what they receive in dividends and in capital appreciation on an annualised basis). The two ought to be very similar. But in fact, earnings yield runs at about 1.5 percentage points per year higher.
The column highlighted research by the great Andrew Smithers who can be seen here discussing his idea with Martin Sandbu, who is doing a great job on the Authers’ Note video:
Mr Smithers’ explanation for the discrepancy, which does not make him popular, is that earnings are systematically overstated – and that the manipulation has intensified now that the modern bonus culture gives executives a much greater incentive to overstate profits in the short term. However, there is another possible explanation.
That is put forward by Ben Inker, GMO’s head of asset allocation, in a lengthy article you can find here. The nub of his argument is that there are two possible explanations. One, as already explained, is that the reported earnings never really existed. The second is that companies did a terrible job of reinvesting their retained earnings. Rather than allocating this capital effectively, they may in aggregate have been guilty of “systematically flushing their retained earnings down the toilet”. Rather than disappear into executives’ bonuses, on this interpretation, they may instead have disappeared into executives’ follies, such as unnecessary and expensive new headquarters (always a red flag). Mr Inker’s most provocative point is that:
retained earnings have averaged 3.3% of market cap. That 3.3% could have been paid out as dividends, and if our earnings were truly economic profit that maintained the companies’ real earnings power, shareholders would have been able to pocket a dividend yield of 7.2% with flat real earnings.
There is probably an element of truth to both explanations, neither of which speak well to the stewardship of companies by their executives. Either argument also leads naturally to an emphasis on dividend discipline. Modigliani and Miller showed that investors should not care whether their cash is paid to them as a dividend or retained within the company; but that equation changes if there are real reasons to doubt whether the declared earnings really exist.
Many thanks to the reader (“dh from texas”) who pointed out the Inker article in response to the original column.