Acorn Clarification

In my previous post regarding the effect of demographics on asset prices, I asserted that “a stock does not represent an infinite stream of dividends subject to the market’s valuation; it represents a finite stream of physical returns.” In the comments section, Gabriel Mihalache appropriately asks for clarification:

…could you please expand on your comment regarding shares? I thought that shares entitle you to dividends in perpetuity, or at least as long as the company exists. When the company sells more, their value depreciates, but ignoring this, I don't understand what you mean by finite stream of physical returns.

It’s certainly true that dividends are what shareholders actually get, for as long as the company keeps paying them, which in the case of successful companies, is usually in perpetuity. However, the payment of those dividends represents the productivity of the underlying assets (e.g. plant and equipment), and any particular asset will typically tend to depreciate (become less productive) over time (or at least, will tend to have a finite useful life). The critical question is what happens when those underlying assets depreciate.

A corporation has a choice about what to do with its cash flow as its current assets approach the end of their useful life. It can invest in new assets, or it can return money to shareholders by means of dividends and stock buybacks. Since corporate managers generally seem to be very concerned about their stock prices, it seems likely that they will tend to make this decision based on maximizing the stock price. When there are a lot of working-age people who want to invest, there will be a lot of demand for companies that invest in productive assets, and the stock market will presumably favor stocks of companies that reinvest their cash flow. If you can say, “Look, we’ve invested in this great new project that is going to produce great returns in the coming years,” people will want to buy your stock.

On the other hand, when most of the population consists of retirees, there won’t be a lot of demand for companies that invest in new productive assets. Rather, stockholders will want to take what the company produces and just consume that product, while allowing the assets to live out their limited useful life. In that case, the stock market will favor companies that pay high dividends and use their excess cash to buy back stock. If you expect to live only another, say, 15 years, you’ll be willing to pay a premium for a stock that promises good payouts over those 15 years even if it will start to become worthless afterward. So even though the transactions are financial and involve things like dividends, the investors ultimately control whether a company reinvests the proceeds from its physical assets, and it is roughly as if those investors owned pieces of those assets directly.

Thus when Prof. Siegel imagines seemingly perpetual financial assets that depend on market demand for their value, he is creating an artificial construct. Ultimately, a stock represents part of (for example) a factory, and a factory really is like an acorn. The squirrels who own it can choose when to consume its output.