Wednesday, October 5, 2011

Investment Lessons from Andrew Carnegie

A little more than a century ago, in 1901, Andrew Carnegie sold his family's interests in its steel enterprises to a group led by J.P. Morgan and Charles Schwab (no relation to the brokerage).

The consortium - which was retitled the United States Steel Company - immediately became the largest corporation in the world, with a market capitalization of over $1 billion.

The sales price was 12x annual earnings (interestingly, about where the S&P 500 is trading today). The total value of the transaction was $480 million, or about $13.7 billion in today's dollars (according to Wikipedia, by way of Gale Virtual Reference Library).

Carnegie's personal share of the transaction was slightly more than $225 million, which was paid to Carnegie in the form of 5%, 50-year gold bonds. According to Wikipedia:

The bonds were to be delivered within two weeks to the Hudson Trust Company of Hoboken, New Jersey, in trust to Robert A. Franks, Carnegie's business secretary. There, a special vault was built to house the physical bulk of nearly $230,000,000 worth of bonds. It was said that "...Carnegie never wanted to see or touch these bonds that represented the fruition of his business career. It was as if he feared that if he looked upon them they might vanish like the gossamer gold of the leprechaun. Let them lie safe in a vault in New Jersey, safe from the New York tax assessors, until he was ready to dispose of them..."

What made me think about Carnegie's transaction was how, in some ways, the world is still struggling to find the right combination of safety and yield.

In Carnegie's day, there was no Federal Reserve (which was actually started in 1912). Deposit insurance was unheard of, and bank failures were not uncommon. Government bonds were relatively scarce, and even if they were, the creditworthiness of the United States was not perceived as strong as other countries like Britain or Germany.

So it would make sense for someone looking to preserve great wealth to look for two key characteristics: first, it had to offer an attractive yield (5% sounds pretty good today!); and, second, it had to be absolutely secure (hence the gold backing).

Unfortunately there are no 5% gold-backed bonds available today. Moreover, the only place that investors can find any sort of relatively safe yield is in dividend-paying common stocks.

Bloomberg had an interesting article this morning noting that while dividend yields are attractive, there is plenty of reason to believe that corporate America can raise payouts significantly in the coming years, especially if stock market returns remain subdued:

Pressure is building for higher dividends as U.S. companies from Google Inc. (GOOG) to Valero Energy Corp. (VLO) sit on record cash stockpiles and payouts remain at three- year lows.

Standard & Poor’s 500 Index companies paid 27 percent of earnings in dividends in the second quarter, down from 30 percent in 2008 and below a 30-year average of 41 percent, according to Wells Fargo & Co. Company cash, equivalents and short-term marketable securities jumped 63 percent to $2.77 trillion in the same period, according to Bloomberg data.

The article goes on to quote several investment professionals noting the extremely high cash levels that many corporations have stockpiled for fear of a repeat of the credit crisis of 2008.

Put another way, stock buybacks and hoarding cash are in some ways a bull market strategy. Investors have no problem not receiving cash directly from their investments so long as their stock investments are rising in value.

However, with the S&P down more than -17% over the past 5 years, and the papers full of recession talk, it seems logical to expect more pressure on company managements to return more cash to shareholders.

Unless we can convince someone to issue 5% 50 year gold backed bonds.