As the Free World engages in its first global conflict of the 21st century, what is a good fiduciary to do?
* Develop long-term strategies of engagement with corporations in which they invest so that democratic capitalism ultimately provides a better balance between the benefits of ownership and those of control?
* Develop long-term strategies to participate in the creation of new enterprises, i.e., through private equity?
* Or should the strategy be to reduce equity exposure until a material positive equity risk premium reappears through lower share prices, and hence higher current dividend yields?
* Or some of each?
These are profound questions that fiduciaries ignore at their stakeholders' peril. Before the events of Sept. 11, they could answer them at their leisure. This is no longer the case.
What about this new war? What incremental resources will be required to wage it, and how will those resources be appropriated? These questions still lie before us, and I don't pretend to have specific answers. However, given the nature of the coming conflict, the required incremental resources should be well within the reach of the Western democracies without causing major economic dislocations, ceteris paribus.
Of course, as Lord Keynes pointed out, invoking ceteris paribus (all other things being equal) is the oldest economist trick in the book. Central bankers can lower short-term interest rates for some time. Politicians can prop up the airline industry for some time. But at the end of the day, the economic health of democratic capitalist economies depends greatly on the presence or absence of "animal spirits." Beyond some basic level of necessities, it is animal spirits that lead consumers to make "big ticket" purchase decisions. It is animal spirits that lead business leaders to make major capital spending decisions.
We believe that readers would be correct to link any dampening of consumer and business enthusiasm for making expenditure decisions to lower corporate profits tomorrow and hence to lower stock prices today. Indeed, this connection already is being reflected in post-Sept. 11 stock market pricing, and thus is hardly news. It still is news in many quarters, however, that a darker scenario could unfold. It is this darker scenario that we feel compelled to sketch out here.
Longer term, stock markets can withstand serious doses of bad news as long as they embody a healthy risk premium over other, less risky investments. If stocks are not priced to produce a healthy risk premium at the start of an extended bad news period, an extended period of poor return performance is a likely consequence.
A paper by Robert D. Arnott and Peter L. Bernstein, to be published in a forthcoming Financial Analysts Journal, suggests that anything over 21/2 percentage points might qualify as a "healthy" equity risk premium. This is only half the oft-quoted 75-year equity excess return realization of five percentage points over bonds. It turns out that out of the realized 5%, about half was expected, and the other half was just good luck. That is the good news.
The bad news is that today, even after 18 months of poor equity markets, it still is difficult to come up with an equity risk premium much greater than 0.5%. What would it take for stocks to offer a 21/2% risk premium today? Very simple. The current dividend yield would have to increase by two percentage points, going from the current 2% to 4%. Painfully, this would imply a further 50% fall in equity prices from current levels.
Why do we think the events of Sept. 11, plus the events likely to follow in the coming months and years, have made such an outcome more likely? For the same reason these events are likely to dampen the animal spirits of consumers and business people for some period of time. Risk has suddenly become a more palpable phenomenon for investors. And if risk is real, rather than just a theoretical concept, it must be tangibly compensated. The only sure way to do that is to raise dividend yields, and, in turn, the only sure way to do that is to bid down current share prices.
A further major fall in equity prices in the current environment is a gloomy prospect. Can anything be done to mitigate such an outcome? The research Arnott-Bernstein present suggests the answer is yes, at least in a longer term perspective.
First, corporations could begin to pay out a higher proportion of their earnings to shareholders as dividends. The record shows the other major activities financed out of corporate earnings (i.e., internal reinvestment, external acquisitions, funding the exercise of executive stock options) are generally not money well spent, from the shareholders' perspective. What can be done to get the boards and management of the Free World's publicly traded corporations to focus more clearly on the interests of their long-term shareholders? Again, there is a pretty clear answer. Only institutional investors with a clear idea of how to serve the long-term economic interests of their own stakeholders can do that. Realistically, they are the only actors in a position to create the mechanisms that could tangibly hold corporate feet to the fire of transparent shareholder accountability.
A second avenue of opportunity for pension funds is a permanent commitment to private equity investing. There is an obvious reason the long-term dividend growth of existing publicly traded corporations is much lower than economic growth generally. The missing element is the significant contribution new enterprises make to growth over time. Funds miss out on this element of growth (and the new wealth it creates over time) unless they consciously choose to be participants.
Keith P. Ambachtsheer is president of K.P.A. Advisory Services Ltd., Toronto. His commentary is adapted from a lengthier analysis in the Ambachtsheer Letter.