As we take time to reflect on the past twelve months, one unmistakable trend of 2002 was the rash of high-profile exits. The list of political quitters covered the entire spectrum, and frankly, some will not be missed: Al Gore, Trent Lott, Harvey Pitt and William Webster from the SEC, and the duo of Henry Kissinger and George Mitchell (who resigned from the 9/11 commission before even picking out office furniture!). On Wall Street, at least four well known bullish market strategists were shown the door as well; a similar story unfolded in 2000 when several bearish seers received pink slips near the end of the Bubble (here's hoping these latest exits prove to be equally ill-timed!). We also learned from its management that Coca-Cola will abandon the practice of providing quarterly and annual earnings estimates to investors (perhaps the start of a trend?). And in September, Sony announced it would finally stop making Betamax video recorders. Sales peaked eighteen years ago, yet Japanese consumers continued to buy a few each year; this proves that eventually, it's just time to leave (Al Gore admitted as much during his exit).

The other important departure in 2002 was Main Street's flight from equities. For the first time since 1988, investors withdrew more money from stock funds than they added. The third consecutive year of market losses weighed heavily on most investors: the economy is sluggish (although growing), despair is high, expectations have fallen and investors' mood rings now flash fear instead of greed. The market's drop last year was exceptionally broad and disappointing: 70% of all stocks declined, and no single industry sector produced a net gain; value stocks, in fact, proved to be the last domino to fall in an ugly procession that started nearly three years ago. While there was no place to hide in 2002, our clients' portfolios performed relatively better than the broad market averages. Over the past three years, our portfolios have produced positive results against the backdrop of 38% and 67% declines by the S&P 500 and NASDAQ. We are thankful to be in positive territory over this time period, but we realize that broad investor discouragement represents a meaningful challenge for the market over the coming months. For 2002, the economy and market were equally disappointing. We hope for the same synchronicity in 2003, except to the upside!

One of the manifestations of investors' disappointment with stocks is an increasing focus on corporate dividends. This topic has jumped to the front page for several reasons. First, market analysts are projecting low returns for the next several years; dividends are thus likely to comprise a greater component of those returns. Second, the current low interest rate environment encourages investors to seek alternative (and higher) sources of income. Third, recent corporate scandals and bankruptcies highlight dividends' role in enhancing corporate transparency - if the cash is available to pay the dividend, the likelihood of malfeasance is lower. Finally, some believe that if all those tech companies had simply paid dividends (rather than buying all that expensive equipment), the overinvestment that led to the Bubble could have been avoided. Many argue the road to riches is just around the corner if only: 1) the double taxation of dividends is halted, and 2) corporations increase their dividend payouts to put more dollars into yield-starved investors' pockets.

On the issue of dividend taxation, the argument for reform is strong. Dividends occupy a unique niche in the tax code, as they are taxed twice: first by the company when it generates a profit, and second when the investor pays income tax on the cash received. All else being equal, this distortion raises the after-tax cost of equity capital (i.e. investors demand a higher return from owning dividend-paying stocks to compensate for the additional tax they must pay). At the margin, this encourages companies to finance themselves with more debt than might be optimal because on an after-tax basis, debt (and the associated interest payments) cost less. Even among economists of different stripes, most agree that this tax on equity capital leads to inefficient capital structure decisions. Repeal or reform of this section of the tax code would be welcome.

Beyond the tax issue, however, we would argue that higher dividends may not be the cure-all that many investors seek. Corporate dividend policy is just one decision among many that management teams must make on a regular basis as they deploy the firm's capital. At Harris Associates, we view the entire capital allocation process - the decision to invest in new equipment, pay down debt, repurchase stock, make acquisitions, or pay a dividend - as the most important job of management. Our investment philosophy is geared to identifying businesses that maximize the intrinsic per share value of the enterprise, and so we are attracted to management teams that allocate capital wisely. When we meet with a CEO or CFO, we try to gain as much insight as possible into how they make these decisions. Ideally, management has a disciplined process for estimating the prospective returns for the various choices, and then follows through by committing capital to where it will add the most value for shareholders. We often have discussions with companies who tell us they are considering increasing the dividend in order to "attract more investors". We think this is foolish: if there are better opportunities available for those funds (a new manufacturing plant, R&D for a promising new product or the repurchase of company stock at a very low price, etc.), then management should deploy the funds in that manner. We believe doing so will maximize the intrinsic value of the enterprise, and over time, the stock price should follow. In fact, management teams that pay dividends just to attract a certain class of investors are, in our view, too focused on "beauty contest" considerations rather than simply running the business.

One more important point: in today's environment (low interest rates, stock prices down after a significant three year decline), higher dividends may be exactly the wrong prescription. Sure, investors may feel better cashing those dividend checks (rather than relying on promises from CEOs and forecasts from Wall Street analysts), but their long-term investment returns may suffer. Over the years, dividends have constituted a meaningful portion of the market's overall return, but capital appreciation has been more important. Companies that pay out a high percentage of their earnings may be ignoring other value-maximizing opportunities, while their shareholders end up accumulating cash in low yield money market funds. Our market experience tells us that our clients' capital is best preserved - and grown - through opportunistic purchases of stocks trading well below intrinsic value. Dividends are certainly helpful in situations where income is the primary objective, but our mission for the vast majority of our clients is to seek high total returns (dividends plus capital growth). This is particularly important today: we think the long-term outlook for capital appreciation is as strong as it has been in several years.

By screaming for dividends, investors are engaged in their own form of exit: they are focused too much on preserving rather than growing their capital over the long run. This is understandable, but we believe it is wrong. Not only has the decline of the past three years corrected much of the overvaluation from the Bubble, but we continue to find attractive stocks trading at low multiples of free cash flow and earnings. As we argued in our last commentary, it is our opinion that the low level of interest rates tips the scales strongly in favor of stocks versus bonds over the coming years.

We admit the macro challenges remain daunting. The world political environment is uncertain, economic growth remains sluggish and investor confidence is low. We have no unique insight on these issues. We do believe, however, geopolitical risks are likely to decline over the coming year. On the economic front, we recognize that cycles are always with us - boom and bust are recurrent themes throughout history. We are impressed with recent corporate belt-tightening, and higher profits are in our forecasts even in a weak revenue environment. Finally, we are encouraged by current sentiment: the more people believe that stocks stink, the better the odds that prospective returns will be satisfactory.

But don't just take our word for it. Recently we reread a Fortune interview with Warren Buffett from late 1999. It was a big deal at the time, because Buffett predicted that stocks would grow just 6% annually over the next 17 years - this was near the peak of the Bubble, and his argument confirmed readers' fears that Buffett was out of touch with the New Era (stocks had grown 19% annually in the preceding 17 years). Well, Buffett proved once again to be prescient, because less than six months later the stock market turned over and has fallen 43% since. Let's assume Buffett was on the mark: from today, what rate of growth over the next 14 years will carry stocks to Buffett's original target? We did the math, and the number is better than 11% annually. That's a healthy rate of growth, and it happens to be very close to the long-term trend rate of growth for stocks over the past 70 years. It is not time to head for the exits.