Last Updated May 1998

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F YOU EVER SUFFERED THROUGH an economics class, you know the market economy is based on supply and demand. Not only does this apply to products, it also applies in the equity markets as well. How does this impact you, the investor? Unfortunately, you can come out on the losing end When the Supply of Stock is in Demand.

Speaking of demand, the Taxpayer Relief Act of 1997 created a hot product, the Roth IRA. Unlike a regular IRA, contributions aren't deductible, but qualifying withdrawals are income tax-free. The appropriate investments differ, too. If you're one of the millions opening one, you should consider that when Investing Your Roth IRA.

What else is on your mind? Let us know. This is the place where questions are answered, issues addressed, and criticism ignored.

When the Supply of Stock is in Demand

"The real price of everything, what everything really costs to the man who wants to acquire it, is the toil and trouble of acquiring it."

-- Adam Smith

 

AVE YOU EVER TRIED TO BUY a ticket to a sold-out sporting event? As you probably found out, you can do it, but at a price. This is nothing more than the laws of supply and demand at work: There's only a limited supply of tickets, so the scalpers can charge what the market will bear. If the event is sold out, you have to pay a premium over the ticket's stated price. Of course, if it isn't a sell-out, you may not be able to give a ticket away -- there isn't any demand.

The same laws apply to financial markets. In fact, this explains a lot of the current stratospheric stock valuations. With interest rates at 30-year lows and 20%+ returns on stocks for the past three years, even CD investors believe they need to be in the market. We're talking major demand here! Although companies periodically issue new shares of stock, the supply is relatively fixed so increased demand drives up the price. Before you know it, the S&P is valued at 26X trailing earnings.

All this sounds pretty good for investors, right? After all, they don't care why the price goes up, only that it does. Well, it is good -- if you're selling. But if you're a buy and hold investor, sooner or later your over-inflated shares will move back towards their intrinsic value. To make matters worse, when demand runs up the price of their shares, some companies begin to fiddle with supply. Guess who gets burned?

Why Futz with Supply?

Now no business has any underlying desire to manipulate the supply of their stock, it's just a result of the present economic conditions. Everyone's looking for earnings, but right now it's difficult to increase sales. Inflation's low and consumers are spending, but not to an overwhelming extent. Cash is available from current sales, but what do you do with it? For many companies, debt isn't a problem, especially with interest rates so low. There's no reason to expand capacity when you have to cut prices to move current inventory. So what do you do?

Well, you can increase earnings per share (EPS) without increasing earnings. All you have to do is reduce the number of shares outstanding. Imagine your company has $100 in earnings and there's 100 shares outstanding. In this case, EPS is $1 ($100/100). Now suppose you reduce the number of outstanding shares to 50. Suddenly your EPS doubles to $2 ($100/50), but your earnings have stayed the same. Investors who only focus on EPS will look favorably on your stock.

How do companies reduce the number of outstanding shares of stock? Simple, they buy it back. It's a good use for cash from current revenues when it isn't profitable to reinvest in the business, and most analysts applaud it as showing the company's support for the stock. In fact, most stocks get a brief pop in price when the company first announces a stock buyback. Remarkably, most buybacks are never fully completed, but so what, the stock price rises and that's what everybody wants anyway, right?

Actually, no. You see, when a company buys back its own stock, it's doing it with your money. That's right, it's your money because it was earned on your investment and could have been paid out to you in the form of dividends. Instead, it's used to increase earnings per share even though it doesn't increase earnings themselves. Sure you benefit if you sell when the stock gets it's initial pop, but if you're a buy and hold investor, it'll eventually come back to its intrinsic value. At that point, your money -- the cash used to buy back the shares -- is long gone and you've got nothing to show for it.

To make matters worse, buybacks often don't even reduce the number of outstanding shares. Companies frequently use options on their stock to entice and incent talented employees. (Technology companies are notorious for this.) Shares have to be available when these options are exercised. If new shares are issued, earnings are actually diluted, but if they can be removed from the market in a buyback and then reissued, earnings aren't impacted. When this happens, your money is used to transfer ownership from investors to employees. Earnings don't go down, but then again, they don't go up. You've basically paid to stay even. Doesn't that make you feel good?

Even if buybacks reduce the number of outstanding shares, unless timed correctly, they still waste your money. Until relatively recently, most stock buybacks only occurred when management felt their stock was undervalued. Perhaps market leaders had faltered and the entire industry took a hit, or maybe they knew some positive information that hadn't yet hit the street. In those cases, it was a good idea to buy back stock when the price was low.

But after the last three years of incredible market performance, almost no stocks are priced too low. Instead, companies are initiating buybacks while their stocks are hitting new highs. When this happens, your money is being used to overpay for stocks that are already overvalued. Would you knowingly invest that way yourself?

Take My Stock, Please!

Of course when tight supply drives a company's stock into the stratosphere, astute management can take advantage of demand by using it as a cash substitute. This is exactly what happens when acquisitions are funded with stock rather than cash. In other words, if you want to buy my company for $1,000,000 and you know your stock is overvalued, why not pay me with stock rather than in cash that's really worth $1,000,000?

Think about it. If your stock was fairly valued, why would you want to dilute your ownership in your company by sharing it with me? On the other hand, if it's overvalued, it'll eventually return to its fair value. Why not take advantage of its fleeting premium to increase your capital? You can even offer me (what appears to be) a sweeter deal with stock since a lot of its value is illusory anyway.

Of course investors are again left holding the bag. Unless the acquired company can actually add to real earnings, nothing has really improved. In fact, if new shares were issued in the transaction, EPS are actually diluted. Shareholders of the acquired company usually also lose out when the buyer's stock returns to its fair value. Everybody loses when shares of the combined company underperform the market.

Actual evidence supports this less than rosy scenario. Tim Loughran and Anand Vijh, finance professors at the University of Iowa, studied the results of mergers occurring between 1970 - 1989. During that period, a benchmark group of stocks appreciated 95%. Stocks of cash acquirers did even better, 113%. But shares of stock acquirers rose only 61%, trailing all categories. Overpriced equities return to fair value, and diluted ones do even worse.

So watch out. If one of your holdings announces a share buyback or an acquisition (either as the acquirer or target), don't get caught up in the analysts' hoopla. Odds are, somebody's fiddling with supply. You should demand better.

Investing Your Roth IRA

"It's exactly the same, only different."

-- Yogi Berra

 

CCASIONALLY TAX REVISIONS ACTUALLY give taxpayers a break. It may not last long, but while it's there, it's worth taking advantage of. The Taxpayer Relief Act of 1997 offers such a opportunity -- the Roth IRA. Named after the politician who pushed it (is that good or bad?), the Roth IRA works similarly to a traditional IRA, but adds the potential of totally tax-free withdrawals. This benefit comes at the expense of the up-front tax deduction for contributions, but over the long-term, it's well worth it.

Just the Facts, Ma'am

As with a traditional IRA, funds grow tax-deferred and can be invested in any manner. But the best thing about Roth IRAs is the totally tax-free withdrawals that can occur if funds have been invested for at least five years and the taxpayer is over age 59-1/2. Not only do these distributions escape any tax penalty, they're totally tax-free.

Just the Tax, Ma'am

So how should you invest your Roth IRA? Should it be any different than a regular IRA? Yep, it sure should. You'll see the numbers in a minute, but first you need a little general theory.

Presumably any IRA is a retirement savings vehicle and as such, is invested for the long-term. In most instances, this would mean you'd need a heavy dose of stocks given they provide the best long-term performance. If your IRA were your only investment account, you'd be well advised to use as high a percentage of equities as you can bear. The only consideration in that case is growth.

But if you have other investments, particularly in taxable accounts, you need to consider tax consequences when investing your IRA. Here's where your holdings in your traditional IRA should differ from your Roth IRA. Why? Well, it all comes down to taxes.

Distributions from your traditional IRA are taxable as regular income regardless of how they were earned. Even if your IRA is 100% stocks and all your withdrawals come from capital gains, for income tax purposes, you still treat them as regular income. Before the Taxpayer Relief Act of 1997, this wasn't such a big deal since the tax rates for capital gains and regular income were pretty close. But now, the capital gains rate for assets held at least 18 months is capped at 20% (dropping to 18% in 2001) while regular income can be well over 30%. For those keeping score, that's approaching a 50% difference -- especially when state taxes are added in as well. We're talking real money here!

So, if you have taxable investments and a regular IRA, you're better off putting your income producing assets in the IRA and keeping your equities outside. That way you'll be able to take advantage of the lower capital gains rates when you trade your stocks and won't have to pay tax on your income producing assets while they grow in your IRA. When all's said and done, you'll end up keeping more of your savings.

Here's an example: Suppose you have $30,000 in a traditional IRA and the same amount in a taxable account. Further suppose you want to invest half in stocks and half in bonds, and you have 20 years before tapping them at retirement. Also assume your stocks have an average annual return of 10% and your bonds return 6% (pretty much the historical averages). If your regular income is taxed at 31% and capital gains at 20%, and if you put your bonds in your IRA, you'll have $213,621 after taxes at retirement. On the other hand, if you put your stocks in your IRA, you'll only have $206,785.

The difference between the right and wrong allocation is even more striking when using a taxable account and a Roth IRA. In fact, the allocation should be reversed! Why? Well, because it's a lot more efficient to pay 31% on a 6% return and no taxes on a 10% return. Using the same assumptions as in the previous example, with bonds in the Roth IRA and stocks in the taxable account, you'd have $243,447 after taxes. By reversing the allocation, you'd have $269,351.

Now if Congress could find some way to eliminate or at least limit taxes on regular earnings, that would really be taxpayer relief!