May 22, 2003
Creating New Demand for Gold and Dividends
By Brady Willett & Todd Alway

A new era of Gold Investing is about to begin

The World Gold Council filed its registration statement for the first tradable Exchange Traded gold Fund in America on May 15.  This new ETF – with each share being backed by 1/10th of an ounce of gold ($37 US per share) – is expected to begin trading soon under the symbol GLD. 

Investing in gold can be a painful process.  If you want to purchase the metal you have to store/insure it, if you want to buy futures/options you have to be prepared to leverage/risk your capital on a timed basis, and if you purchase gold stocks you are purchasing, well, stocks – an instrument, moreover, whose success/failure may not be directly hinged to the price of gold. With these hassles and pitfalls in mind, GLD – with trustee fees of 0.12% - should be a success, because it offers investors gold that trades like a stock. Furthermore, given that the gold being stored for the fund will not be loaned out, it could potentially be a huge success. 

* As shareholders register their shares (in paper form), the number of shares that can be borrowed for short sales is correspondingly limited – similarly, the more gold that is stored in GLD’s coffers, the more positive the outlook for the POG (fewer ounces available to be sold short).

The old era of stock options dilution is about to end

Following the likes of Yahoo, Intel shareholders have become the latest set of owners to vote no on expensing stock options.  However, before Intel management rushes to include yesterday’s ‘no vote’ in their next letter to the FASB, the company should look at the vote totals: more than 47% of INTC shareholders voted to expense options, which is a remarkable high amount given how strongly the company is against expensing.

To begin with, it doesn’t matter whether or not Intel management is correct in maintaining that stock option costs cannot be accurately calculated and so should not be recorded as a cost at all (as pedantic as this argument is). Nor does it matter whether or not Grove and company are wasting shareholder time and money lobbying FASB, writing articles, paying off Congressman, and mailing shareholders propaganda packed anti-options material instead of doing their jobs (Intel makes computer parts last time we checked). No, what really matters is something so simple that even Intel’s hypocrites can understand it: even if stock options are expensed – and Grove and the gang agree on this point – it would not impact (from a cash perspective) the business.

* Why is Intel management so concerned about something that won’t impact their business?  Why not, like most companies except tech, forget about the issue and either expense or wait on FASB?

As for shareholders voting no to expense, it is fairly obvious why: they believe that if the EPS figures flashed across CNBC on a quarterly basis don’t look pretty than no suckers will buy their shares at a higher price.  Yes, this is the blunt way of saying that most shareholders do not want to vote yes for something which could hurt their company’s stock performance, but it is also the subtle way of saying that many shareholders today buy stocks for the wrong reasons (i.e. quarterly EPS figures are useless as a test of corporate performance when compared to ROE and free cash flow).

An Era Better Left Forgotten

Although there was nothing more annoying and ridiculous than fractions (how stock spreads used to be measured on NYSE stocks), the ‘price-weighted’ Dow ranks close.

Charles Dow created the Dow Jones Industrial Average on May 26, 1896.  Without the luxury of a calculator, much less a computer, the Dow average was originally calculated on a price-weighted basis.  Correct that – the average is still being calculated on a price-weighted basis.

General Electric, Intel, Microsoft, SBC Communications and Hewlett Packard combined have a market capitalization of nearly $800 billion.  3M has a market capitalization of $44 billion.  3M represents 10.14% of the Dow whereas GE, INTC, MSFT, SBC, and HPQ combined represent 9.26% of Dow.  Ridiculous is too weak a word to describe how ludicrous this is. 

Honor Mr. Dow; erect a statue, throw a parade. But get rid of his outdated index model.

What if the Dow was weighted like most other major markets?  From December 24, 03 to May 21, 03 the official Dow index gained 0.8%, whereas the 30 companies representing the Dow gained 1.69% in total market capitalization. If someone where to show President Bush this statistic, given that it suggests that the current weighting structure of the Dow has limited the index’s performance, Grasso would be getting a phone call tomorrow to make the change…


The U.S. Government Bets on the Stock Market

Speaking of Bush, his long awaited tax cut proposal was passed (Bush has the votes) yesterday. Instead of the originally planned $726 billion, total tax cuts came in at $350 billion (of which $20 billion has been delegated for state aid).

Before blindly applauding Buffett’s timely comments – which we agree with completely - it should be remembered that the US government is faced with the difficult job of trying to manage an escalating deficit, weak economic growth, and a slumping stock market. As such, and realizing that Bush’s first tax cut (aimed more at the average consumer than this one) was a complete flop, it is not surprising that the President has offered what can be considered an ‘alternative’ tax package.

The premise behind any tax cut is for the cut to have an outsized impact.  Meaning that if a tax cut is to succeed it must have a tickle down effect (i.e. consumers buy products with tax cut money, companies make more money, companies hire more employees, etc.). Quite frankly, if each American is handed $100 of freshly printed money and they stick it under their mattress, the overall economic impact would be nil (or negative given escalating US deficits). By contrast, if each American quickly took their new money and started spending it, the impact could potentially be huge.
 
Such is what Bush’s dividend tax cut focuses on – by planning to ignite a run on stocks he hopes that a trickle down effect will occur. However, in order for Bush’s package to have an outsized impact, you have to assume that American investors desperately want 2% in tax free income (the average dividend yield). You may not need WMD to start and win a war, but you need high yielding stocks to start a dividend-backed rally.

In short, Bush is trying something different, but the same result is likely.

Conclusions

Needless to say, the moment GLD is listed it will be monitored closely for possible Wish List inclusion. Moreover, the moment (and if) GLD has tradable options, formerly ‘buy it and forget about it’ gold investors will be sitting in paradise. To be sure, the ability to easily write long-term covered calls on equity-traded gold is something to look forward to. Unlike writing covered calls on stocks, which carry case to case risks and can be unexpectedly demolished, earning income on gold (a la covered calls) is a safer investment. In short, we would not be a buyer of more hard gold today both because the price may be due for a short term pullback, and because owning GLD is the preferable choice. 

Although we have noted, like many, that Bush’s proposal has flaws, there remains the possibility that the tax cut package will nudge companies to stop using buy backs in favor of paying out dividends (something Buffett did not touch on).  Accordingly, the most optimistic outcome we can forecast for the markets is that FASB quickly forces companies to expense options, that the Intels of the world finally realize their glory days are over and begin paying billions in dividends instead of using billions for buy backs (perhaps because they decide to issue fewer expensed stock options), and investors swarm to mediocre tax free dividend yields.  In sum, and although not likely to save the US economy from years of economic lethargy, Bush’s dividend policy does have the potential for an outsized impact. After all, if you give the already heavily indebted consumer more money they will spend it, but if you give people more incentive to buy/hold stocks (especially the Buffett size investors and/or the wealthy insiders that have been selling) you potentially avert a financial disaster.  Anyone know the after tax yield on the Nikkei?...

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