ETFs For CEOs
October 31, 2008
By Max Rottersman

HANOVER, NH (ETFguide.com) - I was sitting in a cafe the other day trying to explain to Tate, the barrista, why people would buy stocks. It didn't seem so clear to him anymore. We went through the stock table and ended up spending half an hour on the P/E ratio.

He had trouble with the idea that earnings next year would affect the stock price today. For a short period between 1998 and 2000, the P/E ratio wasn’t an issue at all. Nasdaq (Nasdaq: QQQQ) stocks shot up merely on the suspicion of eventual earnings. Today’s P/E for the S&P 500 (AMEX: SPY) stands at 13.47 while the Dow’s (AMEX: DIA) is at 12.45.

No doubt, both will have to be adjusted to the downside. Tate is not the only one confused. Most young people believe stock movements are based on the public response to yesterday's news story.  

No longer are stocks valued based on expected earnings, years-out. Whatever earnings are expected, even if they arrive, are sucked dry by CEO compensation, preferred shares payouts to private equity funds, and management year-end bonuses.

There are so many mergers, buyouts, and bankruptcies that no one thinks to leave any retained earnings for the next whatever. As for the shareholder, within a decade or two that might be the most maligned word in the English language. 

The generation after the Great Depression had a different mindset. They made sure their corporations were cash-rich. Indeed, you could argue that Warren Buffett's chief success with Berkshire Hathaway (NYSE: BRK-A) is due to patiently buying up the companies with the most retained value in the market.  When times began to change he moved to insurance companies which are required, by law, to retain capital.  

Objective Research, FREE >> Sign up for our free newsletter

If mutual funds had biblical text, it might be Jeremy Siegel's 1994 book "Stocks For The Long Run". Part of his thesis is that stocks rise, in the long term, higher than bonds because they must compensate the investor for ownership "risk."

If today someone titled a book "Stocks For The Long Run" the reader would be satisfied if they felt comfortable holding onto the stocks after the 4 pm close. There is no ownership risk today. Unlike investors pre-1994 you couldn't buy and sell from your kitchen, bedroom, or through a cell phone while hiking the Rockies.  

The mainstream media always goes for the cheap, easy story on CEO compensation. A high paid CEO can't possibly spend all their wealth in a lifetime. Most of it is retained in individual stock ownership which is passed on to heirs or philanthropies. The harder story is this: are retained earnings better off kept by corporations or individuals?

If investment bank CEOs were more concerned with their company's corporate finances, would we be in such dire consequences today?  They took all the money when they could. When a rainy day arrived they survived but their corporations didn't.

The secular change in retained earnings ownership, from corporation to individual, may blindside many long-term investors in mutual funds. Popular funds such as the American Funds Capital World Growth (Nasdaq: CWGIX) and Fidelity’s Magellan Fund (Nasdaq: FMAGX) have already racked up huge losses.

Max Rottersman is a partner of Hanover Technology Group, LLC. His opinions don’t necessarily represent the views of ETFguide.com or Yahoo Finance.