Market Breakdown With Steve Forbes
David Scranton: Welcome back to the Income Generation. The show where we provide information for the critical period of people’s lives when they’re either in or approaching retirement. Each week I help you discover useful actions that serve to make this journey much easier, I’m David Scranton your host. I look forward to this opportunity each Sunday to share with you, insight and expertise that I use in my own investment management practice. Insights that you can either use as food for thought or decide to act upon while building or managing your finances as well as the money you will need during retirement. Today on the Income Generation we’re focusing most of our attention on whether corporations, including those that you may be invested in are too focused on short term results at the expense of long term shareholder or investor value. And how this can affect you the Income Generation, first let’s discuss what’s meant by shareholder value, to most analysts myself included is the overall worth delivered to investors as a result of steps taken by management to grow earnings, to pay dividends and to create corporate cash flow. In other words, investor or shareholder value is the byproduct of management strategic decisions. These are steps they’ve implemented that have affected the company’s success in producing net income and affecting share price. So how does a company’s management impact its value? And why is it important to the Income Generation? Well, the best leaders are part visionary and entrepreneur, part risk taker and partner negotiator they know when to be hands on and they know when to delegate. The right balance determines whether a company is incredibly successful or whether it even survives. For the Income Generation focused on retirement goals whether you’re still in stocks or made the decision to rely on income based investments. You don’t have a short term view so it’s best if the companies in which you’re invested doesn’t have a short view either, a company making decisions today that may steal from their strength in later years is not what’s best for you. The problem C.E.O.’s face even the best, is that many investors are short sighted. So a C.E.O. managing with an eye on long term value at the cost of immediate stockholder gratification may see a decline in the price of the company stock. The C.E.O. has to contend with the idea that the average holding period of stocks twenty years ago was five years. Today the average holding period is only five months, so managing to the long term value when he has short term investors may cost the C.E.O. his job. The problem this creates is that corporations are ongoing concerns, if they’re only focused on each quarter’s numbers then their decisions may not include important investments and things like equipment, short term advertising versus long term branding. Decisions that will make for a much brighter year after year but will negatively impact profits this year. It affects whether they borrow to build or spend or retain earnings instead, it also affects whether they pay dividends or buy back their own stock. Or make many other decisions knowing that they’re being measured on how well they’re doing today not tomorrow. This is a real dilemma for corporate management, if decisions they make today steal greater profit from tomorrow which road do they take? The answer very often lies in their incentive plans and other compensation which helps guide their behavior. On today’s show we’ll discuss the importance of this and even how to figure out which companies have a long term focus. You’ll discover why some companies are busy buying back their own stock shares and others prefer to reward investors with larger dividends and most importantly which is my advice for you the Income Generation. These subjects are of particular importance to today’s guest and they should be important to anyone who owns stocks, bonds or mutual funds. I’ll be sitting down for a little Q. and A during the news and views segment for a conversation discussing the investors most affected by corporate myopia. And even those who stand to benefit the most, we can’t really change what’s going on in corporate boardrooms and corner offices but we can change what we do to benefit from their decisions. Now, I want to be fair most heads of corporations are under immense investor pressure, a bright spotlight has been put on stock market value. So managers who don’t excel under these tests tend to wash out, that is to say a manager who gives up short term gain for long term results may simply find himself out of a job. It’s the tortoise and the hare story only with chief executives and the tortoise gets fired partway through the race. Think for a moment about how it got this way? In seventeen ninety-two when stocks were first traded on the New York Stock Exchange few people were trying to build wealth by focusing on the business of others. They were focused on their own businesses, family farm or their jobs. Information moved at a slow pace almost unfathomable today. The fastest transfer of information was word of mouth followed by letters delivered by rudimentary postal service and for those who could get their hands on a newspaper they saw only whatever the printer Dean Worthwhile. Business information wasn’t at the top of that list. Even a century and a half later and with the advent of telephones, radio and television the news reports were not about the stock market. This allowed room for managers back then to manage the business with the goal of long term growth and to maximize return on the resources. It’s only been the last forty years or so that technology and information has change that focus. Today even the average person is aware at some level of what the stock market’s doing day by day. It was in the one nineteen seventies when people begin paying more attention to the markets in part because traditional pension plans were being replaced by 401K plans. And the introduction of mutual funds allowed easier access to many markets, then when cable T.V. provided us with more than just thirteen channels new shows that focused only on business were created. At that point the average Joe developed an appetite for knowing what the companies were doing following stocks and movements were suddenly mainstream and for many became a hobby. Then the speed at which information was transmitted accelerated even more, the internet allowed on demand access to information. No longer did anyone have to wait for tomorrow’s newspaper to learn where their favorite stock traded that day this caused greater participation and even broader interest. In fact, in the nineteen nineties when tech companies were creating millionaires out of stock holders it became very common for people to discuss stocks at social gatherings. And many people became like the Monday morning quarterback, engaged in heated discussions as to which management should be doing what. And why not? If you traded the stock you essentially had skin in the game for many owning a stock in a company is like having a bet on a football team. That bet seems to give permission to question every play the quarterback calls. What followed was online investing and day trading, the news decided to make celebrities out of C.E.O.’s and tell us when they missed quarterly earnings estimates. Or they make other comments on how well they were doing their jobs, all of this attention affects day to day trading and the price of their company shares. So average investors may also be culpable when it comes to pressuring C.E.O.’s to think and act short term. We’ve now reached a point with smartphones where we can watch the market tick by tick from almost anywhere at any time. We’ve learned as a society become very impatient, that’s a lot of stress and pressure on management no matter how much they get paid. With an ongoing intense spotlight on share price it will be difficult and perhaps career suicide for a C.E.O. not to at bare minimum straddle the fence between good and long term management and short term stockholders. Some do this quite well, coming up next in the market breakdown C.E.O. compensation and why are so many companies buying so many of their own shares back are what we’re going to be discussing. Stay tuned.
Market Breakdown:
David Scranton: Today on market breakdown I present to you one of the most troubling causes of corporate myopia and one of the worst symptoms for income based investors. There’s been a lot of noise made in the last eight years or so about high executive compensation, in fact, ever since the financial crisis everyone from the media to the average worker is trying to find a villain. It’s become fashionable to blame C.E.O. pay, typically the protest and finger pointing compares the total compensation of a big corporate C.E.O. against the average pay of its employees. So in this market breakdown I’m not going to discuss the price drivers of C.E.O. pay versus every other worker. I’m going to talk instead about something much more relevant to you the Income Generation and that is why C.E.O. compensation structure is the chief cause of corporate myopia. Also we’re going to discuss how top executive compensation drives management and therefore affects the long term and short term health of a company as well as the company’s credit rating and its stock price. To start the board of directors hires a C.E.O. and sets the compensation, the overall compensation of an S&P Five hundred corporate C.E.O. typically has several components. Based pay, short term incentive, long term incentive, employee benefits, perks and severance or what’s called a change in control package. What may surprise some is that the most valuable part of a C.E.O.’s compensation is not usually salary. Instead it’s the short term and long term incentive plans on bonuses, these are typically a multiple of C.E.O. salary, the salary for IRS reasons rarely exceeds one million dollars a year. But part of their compensation package which in my mind plays the largest part in the nature of their decisions is short term incentive. The second is long term incentive and then third would be change of control or what’s called the golden parachute, these are pieces that cause near-sightedness in terms of overall strength and performance. Here’s why? C.E.O. incentives are most often linked to how well a company’s common stock does short term, that’s the short term incentive. Most executive bonuses are heavily weighted toward year over year measurements of the change in share price this often results in the C.E.O. putting a large emphasis on year over year price movements in that company’s stock. To affect this that C.E.O. may not act in a company’s long term interest and instead avoid long term corporate investment or acquisitions for example. Why? Because that might just dilute shares or diminish profit even if it leads to longer term benefits. The C.E.O. might ignore other smart moves also like divesting in facilities because the one time cost would affect this year’s compensation, even if in the long run the company more than makes up that cost and performs better. Remember, they’re compensated on relatively short term stock price movements, and smaller corporations where it’s an option there is a trend today toward delisting the company from a Stock Exchange for example. This provides management with luxury of basing strategies on longer term goals instead of short term goals, the clamor about C.E.O. pay has brought about a greater emphasis on longer term incentives. This helps keep the C.E.O. focus a little bit more on longer term strategic initiatives but there’s still one hitch. Most of that compensation comes in the form of stock based compensation such as shares that vest, options or restricted shares or even warrants. This still rewards a C.E.O. for steps they may take to increase share price why? Because he or she probably owns a mountain of investments tied to the company’s stock price. In today’s low interest rate environment a C.E.O. may be tempted to take on more debt and then use that debt to boost stock value. Here’s how that works, if the overall market takes a dip for example, it’s natural the chief executive will start to worry about their personal wealth. With low interest rates what an increasing number of C.E.O.’s are doing is instructing their treasurer to buy back shares and finance it with money that’s borrowed at low interest rates. This reduces the number of outstanding shares, increases demand thus nudging their stock prices up. But the company’s credit rating and possibly ability to be nimble later on financially might just suffer, this is not the kind of management a longer term investor wants especially a member of the Income Generation. Buybacks are one of the symptoms of myopic shortsightedness, corporate buybacks for the S&P Five hundred companies run the rise last year as the stock market was flat. In the third quarter they rose over the previous quarter by over fourteen percent for a total of one hundred and fifty billion dollars’ worth of companies buying back their own stock. In all seventy three or about fifteen percent of the Fortune five hundred companies bought their own shares in the market over the previous twelve months. This reduced the outstanding shares in the S&P Five hundred index by four percent compared to the previous year. The main reason, chief executives were taking advantage of low interest costs and borrowing to increase buybacks and reduce the supply of outstanding shares. That’s long hand for decreased supply to help drive up stock prices. Now this is nothing but smoke and mirrors because it serves to also increase their earnings per share. Earnings have been faltering for many of the S&P Five hundred, the way the math works is they couldn’t increase earnings so they decreased the number of shares. This increases the earnings per share because there’s fewer shares outstanding. It also helped bolster stock price which is most of their compensation. There’s been a long debate about whether stock buybacks create any value or if the practice was just a complete waste. Personally I think if the compensation plans were different there would be fewer buybacks and more dividend distribution. This of course, would benefit you the Income Generation. I’m going to be sitting down with Morgan a bit later on the show to discuss the benefit of dividend verses stock buybacks. But first, I’m going to welcome my very special guest, a guy who can lend a great deal of insights and to where value comes from. I think you all recognize this very special guest. Stay right here, we’ll be right back as the Income Generation goes one on one. I’d like to welcome my guest Steve Forbes back to the show, last time I had Steve on Income Generation we had an encouraging conversation about his new book entitled Reviving America. How to repeal Obamacare, replace the tax code and reform the Fed and how that will restore hope and prosperity. This morning Steve, we’re talking about corporate short sightedness. We’ve been talking about decisions at the top levels of corporations that are often driven by what’s best for the executives not necessarily for the customers or even the long term outlook for the company itself. But before we get to business, I want to tell you Steve that you make me feel like I’m back in Catholic school again you know why that is?
Steve Forbes: No, I’m not wearing a nun’s outfit so…
k
David Scranton: No you’re not. Thankfully you’re not but you have a screen there in New York in our studio where you can see me by any chance?
Steve Forbes: No, no. So I have to take you on your word.
David Scranton: Well you see I learned in our… after our last interview what a gentlemen you truly are. Do you have any clue why that is?
Steve Forbes: I sent you something.
David Scranton: Yes, you see normally a host should be so grateful for having the guest that the host should send a gift to the guest. In this particular case the guest sent a gift to the host and I don’t know if you’ve seen any of our commercials but we had a fun with a commercial Steve. Where I talked about all the reasons why I will not wear a necktie on the Income Generation show, but I decided today was the day that I had to break my rule just for you. And if our camera crew could help me out for just a minute, I’d like you to zoom in here and take a look at the tie that was a very gracious gift from Steve Forbes. Written all over of course the capitalist tool and you like me I know Steve are certainly a capitalist. So let’s do this.
Steve Forbes: Well then this makes you the best dressed person on the earth today.
David Scranton: That’s right, that’s right. I feel well dressed, thank you very much. Listen you know we have the best system in the entire world in terms of capitalism, but we’re talking about today is the fact that it’s just it’s not perfect. And first of all, I know you agree but if you want to share in your own words for a moment with our viewers why you believe that there’s a little bit of an issue or at least a bit of an issue with corporate myopia in our country given our current system.
Steve Forbes: Well, I think what you see unfolding today whether it’s in the corporate boardroom or other aspects of the economy is what happens when you have bad economic policies. The system doesn’t work when you keep making mistakes whether it’s undermining the dollar, binge spending, regulatory tsunamis which are especially harmful to small businesses. So people respond to the environment in which they find themselves and today we don’t have real free markets as you know and we’ve discussed this before. Free markets when allowed to operate always turn scarcity into abundance and then we see that whether it’s flat screen T.V.’s, cost ten or fifteen thousand dollars a few years ago. Now it’s a few hundred bucks, smartphones first one from Motorola three thousand nine hundred and ninety-five dollars thirty years ago. Today many plans will give the things away, soon they’ll be a fifty bucks if you want to buy them retail, whole world at your fingertips. So when we look at what’s going wrong around us, the origins. I think we have to get the policies right and then I think we can more successfully attack the shortcomings that we see out there.
David Scranton: Now, of course, there’s been rumors in Washington where they seem to be trying to solve this so-called problem by curbing C.E.O. compensation even more than it is currently. What effect do you think would that have if that ever made its way through?
Steve Forbes: Well, what you see in Washington often is what you might call the Washington version of whack a mole. They see a problem they don’t realize the origins of it so they whack it and then the more problems arise up. A good example talking about C.E.O. compensation back in the mid nineteen nineties when soon after he took office, President Bill Clinton decided C.E.O.’s were making too much money. So they put a cash cap on CEO pay of a million dollars a year and they wrote it in such a way that lawyers had a field day but what that led to was then a huge emphasis on stock options. And we know where that led, so the key thing is in terms of reigning in rapid CEO’s in addition to a Boards of Directors is this shareholder activism that we see out there. Not all of them do well these activists but they do put a little bit of the spotlight on what they think are C.E.O.’s who aren’t performing.
David Scranton: I know your philosophy on taxes and capital gains taxes specifically but for our one or two viewers that may not have tuned in the last time you were here on the show with us. Tell us what you think a change in capital gains rates would do to this corporate myopia? Would it be a positive, would it be a negative?
Steve Forbes: Well, if you did the whole thing on the tax code and I think we’re starting to get a real discussion of that and jump the tax code and put in something like a simple flat tax. Sharply reducing the capital gains levy or getting rid of it altogether, some countries are doing now you would see a wholly different environment. Right now when you have a sluggish economy it puts the emphasis on what you might call financial engineering, which is buying in stock great for the shareholders but not often the best use of capital. Mergers and Acquisitions sometimes they work out but that’s not the same thing as starting new businesses, really vigorously expanding existing businesses. So when you get a tax code that does not reward success that punishes you if you start to earn more money, you get a distorted, deformed economy. And that’s what we see playing out today, if you’re on salary given this current tax code as you know it is very hard to really accumulate capital. It punishes people who need all the removal of barriers, all the incentives they can get to move up the economic ladder to rig system and it’s a rigged in a way where cronyism. Who you know in government soon counts more than what you do and providing things that people want in the marketplace, new products, new services, proving existing ones, making them cheaper, better and the like.
David Scranton: That’s great. Cronyism, I want to talk about that a little bit more after the break we need to take a quick commercial break now. Stay with us, we’ll be right back with more from Steve Forbes. Welcome back, I’m here today with my new friend someone who needs no introduction at all Steve Forbes, author of the new book Reviving America, how repealing Obamacare, replacing the tax code and reforming the Fed will restore hope and prosperity. Steve, see how simple it is all you do is get me a simple gift and I consider you a friend for the rest of our mutual lives, isn’t that amazing how simple I am.
Steve Forbes: All reciprocity.
David Scranton: That’s right.
Steve Forbes: Makes for a much nicer world.
David Scranton: That’s… See you put me on the spot here and all of our viewers know that I reciprocity is what I need to provide at this point. Listen, right before the break we talked about taxes and you had insinuated that having a reduced capital gains tax or even a limited capital gains taxes. Other countries might actually be something that gets corporate C.E.O.’s and executives to focus a little longer term. But also even just having a differential between short term and long term you know if they pushed long term capital gains rates out several years wouldn’t that also help to a certain degree? Have people be a little bit less myopic in corporate America and a little bit more long-sided?
Steve Forbes: Well, you have to recognize that people have different investment objectives and some investors that want to do companies that have starting to prove themselves, they want to hold them long term. Others just want to get them you know especially in venture capital, get them out there and then take the money out do an IPO and then go on to the next one. So one formula doesn’t fit all, but one of the things that I think a shareholder activists have to put more emphasis on is that C.E.O.’s have to do a better job of explaining what exactly is their strategy? Why should you put money in that company? The classic best example today is Amazon, Amazon made it very clear at the beginning Jeff Bezos the CEO that they’re going to pour every cent, every dime of capital they can get. There’d be no dividends, profits were going to be scamp, they were going to pour everything they could to rapidly grow that company. So even though on the profit side Amazon hasn’t had much in the way of profits, Jeff Bezos made it very clear they’re going to grow the top side, the revenue side and go hell bent for leathers they used to say. And make that company a retail giant, innovating in terms of the delivery and everything else and occasionally when expenses got out of control he will pull back. Got expenses under control and then went running ahead so the fact they don’t deliver much in the way of profits. Investors know that but they see the top line growing, they see the innovation coming and so the stock has done extremely well. By contrast for years I.B.M was doing very well (unclear 25:48) gauge went a little overboard in the financial engineering using all their cash to buy in stock. So even though the top line was not doing well they showed a good bottom line but it was a short termism, so shareholders have to… C.E.O.’s a part of the obligation they should have is putting out there what are their objectives? What are their metrics? What should you expect? You see this really David, in health care a lot of these new start… a lot of these startups they’ll tell you for a while it’s just going to be absorbing a lot of cash as they’ve develop a couple of new drugs or medicines. And if it hits you’re going to do very well but in the meantime you’re going to know it’s going to require a lot of investment before this thing can be brought to market.
David Scranton: I think that’s an important point because when you talk about all the financial engineering you could financial engineer the bottom line, the profits. But you can’t financial engineer revenues, you can’t fake it either revenues are coming in or not. How about somehow that if bonuses were tied more closely to the top line? How do you think that might change the motivation of today’s C.E.O.’s and management teams?
Steve Forbes: Well, this is where it gets to be not a science but an art and this is where the compensation committees on boards of directors need to be held more of a spotlight on them. And that is if you’re going for growth okay, good grow the top line but don’t do so in a way where your expenses are going to end up undoing the company. And that’s what Bezos has been… Jeff Bezos of Amazon has been very good at making sure that the top line grows without wrecking the company and so you have to have various metrics in there to be sure that focus on one thing doesn’t come at the expense of everything else. And this is where startups often get in trouble, they see off sales are doing very well but they lose control of their cash flows, they don’t do that very well and bomb they’re successful but they go broke and they don’t understand why. So you’ve got to tailor it to the specific company and that’s what we need more of, this kind of fine tuning. What are the proper metrics for the company at that particular time?
David Scranton: I agree completely, you’d mention before the break Cronyism was the word that you’d used and some call it special interests or lobbyists. And in this political year I know you’re no stranger to politics, so in this political year what do you think could be done to help solve this problem from the special interest side, the cronyism side?
Steve Forbes: Well in addition to a more transparency, the key thing is this is a mantra that we haven’t been very successful and the acting is make government smaller. If you have a large government that becomes more and more involved in more and more aspects of our lives more and more businesses. I mean whoever would have thought that Washington now would be trying to control the internet the way they did the dial up telephone back in the nineteen thirties. It’s really starting… it’s going to be a real dampener on the growth of the Internet in the future where you got to get permission if you want to start a website and that kind of thing. And when you have that kind of more and more regulation and that kind of top down to attempt to control people. You’re going to have to lobby Washington otherwise they’ll kill you, you reach a certain company size in this country and if you don’t have lobbyists in Washington. The political class will come and exact tribute from you, they will come and get you it’s a hideous system were developing today so that’s why we got to pair back in government. Not safety nets but this regulatory blizzard that we’re going through now where they’re trying to control everything we do, you get up in the morning they want to tell you what to do and it’s ridiculous. But they’ll do it unless they’re stopped.
David Scranton: Great. Well, you heard it straight from my new friend Steve Forbes smaller government, not bigger government is the answer. And I think most of our Income Generation viewers would absolutely agree. Once again, it’s been a real…
Steve Forbes: By the way a good way to a good way quickly Dave, to think about it. If you complain about mosquitoes, drain the swamp that’s how you get rid of the mosquitoes.
David Scranton: That’s right, solve the problem not the symptom. Agree completely, it’s been a pleasure having you on the show once again thank you.
Steve Forbes: Thank you.
David Scranton: And now you have the entire Income Generation holding me accountable for my new word of the day reciprocity. So stay with us we’ll be right back after the break where Morgan and I go one on one to talk more about corporate myopia and maybe even come up with a solution or two beyond what your heard today from my new friend Steve Forbes. We’ll be right back, stay with us.
Morgan Thompson: Okay, David let’s make sure we all understand this because it’s very important and it’s what we’re talking about today. So public companies can return money directly to shareholders as dividends but instead they’re buying their own shares and this could benefit the C.E.O.’s overall compensation is that correct?
David Scranton: Yes, because typically the C.E.O.’s compensation is tied to the price of the stock not necessarily the total return which includes dividends. So therefore, the money gets paid out in a form of a dividend, its money that leaves the company and as a result is not going to help that C.E.O. compensation. Where the money that stays in or is manipulated through a buyback could at least potentially help them increase their bonuses.
Morgan Thompson: Okay. Well it explains why they do it but from the stock holders perspective how does a buy back compared to a dividend distribution for them?
David Scranton: Well, for shareholders the big difference is some people are invested for growth and they want to get capital appreciation they don’t want a big dividend because they don’t want to pay taxes on it nor do they need it.
Morgan Thompson: Okay.
David Scranton: Others want to invest for income, so it depends upon the person that you’re attracting as a general rule our Income Generation viewers want stocks that are designed for dividends. Because they’re either in retirement or close to retirement so they want income whereas younger people typically want growth or capital appreciation.
Morgan Thompson: Right.
David Scranton: So the problem with that is that corporations that really try to manipulate the stock price upward in lieu of a dividend are actually in some ways attracting younger investors. And of course, younger investors don’t have as much resources to buy the stock as our Income Generation members.
Morgan Thompson: So it seems to me like unless you need the income which would be great from dividends then stock buyback is great because it just increases your net worth. So what’s the downside? There’s got to be a downside, there’s always a downside.
David Scranton: Well it is it and isn’t because the issue is, I want everybody to understand is that there’s the traditional argument is do we keep cash in the company and therefore our net worth is higher or do we pay it out in the form of a dividend and the net worth goes down, but you get the dividend? What you’re now integrating is a third riskier strategy whereby they’re keeping the cash in the company.
Morgan Thompson: Right.
David Scranton: But now they’re taking it and using it to buy back the shares. So now the cash is out and the shares are back in.
Morgan Thompson: Okay.
David Scranton: The problem is there’s no guarantee that that’s going to have any lasting effect in the increase in the stock price and it could look good on paper but then if the whole market doesn’t cooperate and the whole market slides. Now they don’t have the cash anymore, they’ve got shares that are worth less.
Morgan Thompson: So if you take the dividends you have a bird in the hand and guaranteed cash.
David Scranton: And that’s exactly the term that we always use the bird in the hand. Imagine for a moment that your grandfather for example, own General Motors stock. In two thousand and eight, he might not have been too happy because General Motors was going bankrupt, right? And as a result thinking wow here goes some of my retirement money that’s gone, but at least the good news in his case is that he would have at least had all those dividends that the company can’t take back. That he received early on his retirement years. Now, on the other hand, if he owned another company stock in a different company that didn’t pay a dividend he would have lost everything. He would have lost literally one hundred percent and that’s why I say that the dividend is really truly the bird in the hand, the capital appreciation or an increase in value can disappear in a day in the stock market. But once you get the dividend, nobody can take that dividend back.
Morgan Thompson: So in theory if you had gotten your dividends you would have all this money in the bank rather than your money be in a stock which could potentially be worthless or severely devalued?
David Scranton: That’s correct, and the corporation at bare minimum could have the money sitting in the bank and it’ll be worth more, at least they know what that cash in the bank is worth. But the problem is because corporate officers today are trying to increase the stock price and in fairness to them as I mentioned earlier in the show it’s part of their fiduciary responsibility to do so. The reality is that by trying to manipulate that stock price upward they’re not happy just keeping cash lying fallow sitting in the bank. They want to at least use it to prop up the stock prices and they hope that that stock that they now own in their own Treasury at least will continue to grow and therefore make the company itself worth more.
Morgan Thompson: Which sounds great but if the market crashes then I could be left with diddly.
David Scranton: That’s right, diddly. Now diddly is one of those terms that I didn’t exactly learned in Charter financial analyst school I must admit but I guess it’s okay if you use the term diddly. That’s okay.
Morgan Thompson: You know it’s a (unclear 35:08) so what would you tell people to protect themselves? How do I protect my nest egg if I am heavily invested in stocks? Should I hope for the dividends or sit tight, try to get out, reduce my position what would you suggest?
David Scranton: Well do you mean if people have a small percentage of their money in stocks or people that are members of the Income Generation want you to lecture speculative and have a majority of their money in stocks.
Morgan Thompson: I would say for people to have the majority because they’re the ones most at risk.
David Scranton: So there’s two answers to that. The first answer is that people who are members Income Generation who are going to retire within ten years or who are currently retired. They shouldn’t have majority of the money in the stock market even if it’s income generating stocks.
Morgan Thompson: Okay.
David Scranton: Let’s say the average dividend today is probably only two percent on a stock portfolio and that’s if you own a large bluer chip type companies.
Morgan Thompson: Hard to live off that.
David Scranton: And it’s hard to live off that you know put it in prospective if you want retire with one hundred thousand dollars of income. You need to have two and a half million dollars in a stock portfolio, so the reality of it and actually that’s not even true so you threw me off. You use the word diddly so now I’m thinking two percent on two and a half million is one hundred thousand but no, really you need five million dollars in that stock portfolio at two percent to generate one hundred thousand a year.
Morgan Thompson: That’s just not making your money work smart for you.
David Scranton: And you’re absolutely right that dividend rate is diddly. So that’s why I always tell our Income Generation members that they really need to focus on having a majority of their money in non-stock market income generating alternatives. If you want to have a small percentage in the stock market that’s okay. That’s alright for somebody but that small percentage should be in more dividend paying stocks.
Morgan Thompson: So you can say that more like your fund money if you will and like it’s like going to the casino and gambling and then you put your other money in a state tried and true investments.
David Scranton: Well, when you’re talking about people who are retired or close to retirement you’re… Yes, in a way it could be fun money but for many people it becomes an inflation hedge because there are bonds and bond like instruments pay a fixed income. And they’re hoping over time the stocks appreciate in value as an inflation hedge but at least if the stock depreciate before they appreciate at bare minimum because they have dividend paying stocks. At least all of their assets are paying some income not just the bonds and bond like instruments that they focus on with a majority of their money. But also the minority of their money that’s invested in the stock market as what they hope is an inflation hedge for the future.
Morgan Thompson: Wonderful thank you so much.
David Scranton: Great. Good well stay with us we have to take a commercial break. We’re going to come right back after this and we’re going to talk more about some of the problems that occur with this corporate greed if you will. And how it might not just move somebody’s financial health but it could literally mean their physical health, we’ll be right back.
We’ve spoken a lot today about short sighted companies and why they seem to be managed with only the immediate future in mind. Now, I’m going to talking about just one more critical problem with companies that focus on the short term and then before we run out of time we’ll talk about what investors can do about. There are short sighted and I’ll even throw in cold and heartless companies that knowingly released a product that could turn into a disaster. They’re aware of it but ignore it anyway, the most recent example of this of course, is Volkswagen. If you’re not familiar, last fall there was mounting evidence that Volkswagen had intentionally added a computer program on at least some of its models, to defraud emissions tests. Eventually the EPA discovered that four hundred and eighty two thousand Volkswagen diesel cars in this country alone were emitting up to forty times more toxic fumes than permitted by law. Forty times, Volkswagen sold these cars knowing they had emissions problems but instead of taking the far sighted plan and fixing it which would have reduced immediate profit. They reprogram the computer to trick the emissions test into thinking these cars were within the right range. Now, fast forward a few months and Volkswagen not only faces public relations problems they’re also considering footing the bill to purchase back more than one and a half million cars. Additionally, they’ll probably be hit with lawsuits related to health and safety issues costing many times more than if they were future oriented and didn’t cheat in the first place. The same has been true of many other companies over the years you remember the Ford cars and trucks that caught fire and the Firestone tire blow out issues. Well as a host of chemical companies, paper producers, restaurants and pharmaceutical giants that saved a small amount in the short run but pay dearly down the road in the long run. All because of corporate shortsightedness, this is corporate myopia at its worst and I’ll emphasize it cost shareholders and cost management their jobs. Employees their pensions and ruin the health of customers. In some cases the so-called cheating has put the company out of business so the question becomes, what can you do about this corporate myopia? I’m not sure there’s a perfect way to defend yourself from outright fraud, corporate cheating or management simply turning a blind eye to problems that will cost them down the road. This is really a problem of oversight, investors should pay more attention to whose put on the board of directors for example, admittedly that’s not always easy. The first place that the Income Generation can benefit from corporate myopia is if you’re going to be in the stock market at todays near record highs. You at least can put yourself in a position to collect high dividends from highly rated companies, if a corporate C.E.O. has been a place for a while and they’ve paid a consistently high dividend it may be worth just taking a bit of a deeper look. You can find executive level compensation and information on of any public company by going to the SCC dot gov. website. The analysts at my company for example, Sound Income Strategies also like to look at dividend growth. They like to look at low debt to equity ratios and a high ratio of short term assets over short term expenses i.e. a lot of liquidity. Another favorite ratio of analysts is what we call the coverage ratio, this applies specifically with fixed income bonds and bond like instruments. This measures how many times a company can cover its annual debt expense relative to its cash flow, but with all of these in the end even great numbers may be ignored and the company overlooked if we discover a management compensation package that rewards this short term side of decision making. For investors looking at bond yield it helps to determine if the company is going deeper and deeper into debt and to try to determine what the bond issuance proceeds are actually being used for. If a company continues to mount debt, eventually it can get downgraded by a rating agency. If the economy or the related industry is hit with hard times it could even miss payments on debt obligations. Remember, leverage is a double edged sword the benefits of boring for any reason can magnify the outcome whether the outcome is good or the outcome is bad. There’s been a huge push recently to help fix corporate myopia problems by linking the company’s debt costs in the C.E.O. total compensation package. What this would accomplish is align the C.E.O.’s interest exactly with that of you the Income Generation. Linking the two together could incentivize them to steer away from taking risks that might cause downgrades or eventually alienate creditors. Another method that’s becoming more common is preventing executives from dumping personal shares until several years after their granted to them. This could give them a better reason to think long term if they are forced to hold their shares long term also. Other compensation packages strive to be even more fair to everyone involved, these agreements include share price movements relative to the overall market for example. If the stock market is weak the compensation package may allow for weaker results. This helps in two ways, first it doesn’t encourage the C.E.O. to take missed steps to nudge up prices and it doesn’t cause a C.E.O. to just give up because the goal is impossible and out of their control. Measuring market moves against company moves will ensure that manager’s interests are more closely following those of the company and you its shareholders. As always the Income Generation is here each week for you as new ideas and other important information needs to be disseminated. You’ll get an in-depth look on our show, soundbites often create more confusion for viewers so I leave that kind of reporting to others. We’ve gotten some great suggestions on subjects you’d like us to dig into. All good ideas, all ideas we hope we can get to throughout future shows, keep them coming please. I’d like to thank my guest for spending time with us today as his insights are pure gold to this and almost any other audience. Also, I’d like to thank Morgan with her questions on how dividends are superior to stock buybacks most of the time. I want to thank each of my viewers, I’m glad we have this time together each week. I invite you to head to the Income Generation dot com and let us know just a little bit about yourself. Well that’s all the time we have, I’ll see you all again next week.
