By Christopher M. Wright

NAME: James K. Glassman TITLE: Resident Fellow, American Enterprise Institute (AEI) BORN: 1947 EXPERIENCE: Glassman has been at AEI for nine years where his brief extends to economics, the stock market, Social Security, and beyond. Prior to that, Glassman served as publisher of the New Republic, president of the Atlantic Monthly, executive vice president of U.S. News & World Report, and editor and part-owner of Roll Call (a Capitol Hill newspaper). He is the author of two books on investing, “Dow 36,000” (with Kevin Hassett, Times Books 1999) and “The Secret Code of the Superior Investor” (Crown Business 2002). His syndicated columns and other writings have appeared in, among other publications, the Wall Street Journal, Forbes, the New York Times, the Washington Post and, most recently, Kiplinger's Personal Finance magazine. He is host of the technology commentary Web site www. TechCentralStation.com. He hosted “Techno-Politics” on PBS and moderated the “Capital Gang Sunday” show on CNN. A Harvard graduate, Glassman is chairman and co-founder of the Investors Action Alliance, a small investor education and advocacy group in Washington, D.C.

Through his books and regular columns, influential market commentator James K. Glassman has been explaining the basics of investing and providing stock tips to a generation of small investors. Portfolio recently visited Glassman in his office in Washington, D.C. and, after talking about his Fred Astaire and Ginger Rogers movie posters, we delved into Glassman's views about REITs, the workings of the market, and the need for small investor advocacy where public policy is made.

Portfolio: You cheered up a group of REIT executives in 1999 when REIT stocks were under severe pressure by saying that the market would eventually reward REITs for their good fundamentals. You were right, but why did you think so at the time?
Glassman: The essential question was whether REITs were sound businesses that were simply being ignored by the market. It was clear to me that the fundamentals were quite good and that the market was more interested in go-go high-tech stocks at the time. Markets aren't efficient all of the time. But, like Warren Buffett says, eventually, prices catch up with good real-life performance.
Portfolio: You co-wrote a bestseller in 1999 entitled “Dow 36,000” which received its share of criticism. Obviously in hindsight we know the Dow didn't get anywhere near 36,000, but you wrote in December 2004 that you were unrepentant. Why?
Glassman: I do regret the title of the book because it became, unfortunately, the poster child for the high-tech boom. People who didn't read the book thought it reflected the mania that was going on but, in fact, it was a very conservative analysis of a phenomenon that nobody could explain very well—why had stocks risen so fast and so far from 777 on the Dow in 1982 to about 10,000 at the time we wrote the book. That's a 13-fold increase in 20 years not including dividends.

We looked at the equity premium puzzle that had baffled economists for a long time: stocks historically return far more than bonds, about 7 percent after inflation versus 2.5 percent after inflation on medium-term Treasury notes. And yet, as many studies have shown, a diversified portfolio of stocks is no more risky than bonds over the long term. Jeremy Siegel's 1995 book “Stocks for the Long Run” makes this point very cogently looking at stock and bond prices and volatility going back 200 years.

My co-author and I concluded that people were becoming more comfortable with risk and were bidding down the equity risk premium, the extra return investors demand to compensate for the risk of being in the stock market. When you do that, you bid up stock prices. We said in the book this had been going on for 20 years and we suspected that it would continue for the foreseeable future, with the warning that there could be problems along the way, including recessions and international security disturbances. We said the equity premium would continue to fall over the long term and, as that happens, we projected that the Dow would rise roughly to 36,000. Then this very fast one-time rise in stock prices would level off and stocks would eventually begin returning not very much more than bonds.

Portfolio: Is there any evidence that investors are getting the message that a diversified portfolio of stocks is no more risky than bonds?
Glassman: The best evidence for it is that, despite all of the events in the last four years that would normally be quite disruptive—the collapse of tech stocks, the terrorist attacks on Sept. 11, the first recession in 10 years, and the rise in budget and trade deficits—you see P/E (price-earnings) ratios holding up very, very well. We've been in a rough patch, and I think we're pretty much out of it, and we look for the increase in stock prices to resume.

In previous recessions, P/Es dropped to eight or 12 but average ratios have really not gotten below 18 or 20 on the S&P 500 this time. I think that's an indication that people have learned that stocks don't carry as much risk in the long run as previously thought when held in a diversified portfolio.

Portfolio: You have said it is outdated to use an overall P/E ratio to gauge whether the market is overvalued, that historic averages and ceilings are now meaningless. You argue that market P/Es will stay above their historic average of 15 more or less permanently going forward. Do you still believe that and why?
Glassman: So far they have. The last time I looked, the P/E ratio on the S&P 500 was 20 and that was despite the fact that there was a leveling off of prices in the first half of 2005 and a fairly rapid increase in profits—around 12 percent. This has dropped P/E ratios, yet they are still historically high.

Things really do change in markets. Up until the 1950s, it was taken as a matter of faith that the average stock should pay a higher dividend yield than a medium-term Treasury note. All of a sudden, stocks were paying a lower dividend yield than bonds but stock prices did not fall. The perception of the riskiness of stocks versus bonds had permanently changed.

Similarly, things changed in the early 1980s. The economy, American businesses, and the Federal Reserve all improved in the way they operate. At the same time, investors have been educated that a diversified portfolio of stocks is no more risky than bonds in the long run, and institutions have made a number of changes—like 401(k)s and other tax-deferred accounts—that encourage people to own stocks for the long term.

If you believe in reversion to the mean, P/Es should be seven or eight after the terrible period we've been through, below the historical average. But valuations remain high historically—they're not reverting to the mean—and I think that will continue.

Portfolio: Your focus has been on retail investors. What percentage of REITs should retail investors have in their equity portfolios and why?
Glassman: Generally what I say is around 10 percent, but it could be more. Five to 15 percent is good. There are basically two reasons to hold REITs. First, I believe people's portfolios should look like the economy, and REITs are the best way for small investors to own commercial real estate which is a big part of economic activity. Number two, REITs have proven to be relatively stable in terms of price appreciation and, in general, good generators of income. It is these kinds of stable growers with dividends that I think people should own in their portfolios.

Given the difficulties of understanding financial statements and the ambiguities of GAAP accounting, I've always believed that dividends are the clearest manifestation of a company's financial health. If you see a company that is consistently paying a dividend and the dividend is rising, you get a pretty good sense that the company is sound and growing.

Portfolio: In your books, you point out that, through dividend growth, the dividend yield on stocks held for a long time can become quite high relative to the original investment. You give General Electric as an example. If you bought GE in 1989 at $11, dividend growth made your dividend yield effectively 12 percent in 1999. How do REITs stack up with regard to dividend growth?
Glassman: Generally, really, really good. Pick any REIT in Value Line. Let's look at Equity Residential (NYSE: EQR) for example. .... You see very consistent dividend growth. Starting in 1995, you saw $1.09, $1.18, $1.28 and so on, until it got stuck around $1.73, but this year it's $1.80. So over a 10-year period, you've got about 80 percent dividend growth at a compounded rate of somewhere around 6 percent a year. That means the dividend will double every 12 years [using the rule of 72]. That seems to me to be about average for the industry—mid-single digit growth, but it's pretty consistent and that's very nice to have.

Portfolio: You wrote in 2003 that the best way for retail investors to own REITs is through mutual funds. Still the case?
Glassman: Yes. Most people don't have a big enough portfolio to include companies in all the REIT segments—office, retail, apartment, etc. The best way to own a diversified mix that comes close to representing the entire sector is through a mutual fund.

Exchange-traded funds are also a good way to own REITs. Personally, I own Cohen & Steers Quality Income Realty Fund (NYSE: RQI), a closed-end mutual fund. I owned individual REITs before that but have consolidated my REIT holdings into RQI.

Portfolio: You're a long-term investor, a buy-and-hold kind of guy. You discuss when to sell in your book “The Secret Code of the Superior Investor.” Do you have any new insights on this vexing question? Glassman: Selling really is the hardest thing about investing. Most people sell because the share price has gone up or down, but I tell people only to sell if some fundamental change has occurred within the business that is troubling to you in some way.

The one thing I didn't emphasize enough is the issue of rebalancing. If you own 20 stocks in equal amounts, and one goes way up in value, suddenly it's no longer 5 percent but has become a much bigger percentage of your portfolio. You need to trim your holdings back. There are some difficult issues involved—capital gains, how much to trim—but people need to understand that they should do something when their portfolios become unbalanced.

The lesson of the late 1990s really was a diversification lesson. People's portfolios became wildly unbalanced when their high-tech stocks increased in value a lot more than their other stocks. I know lots of people who started off 20 percent high-tech whose portfolios became 80 percent high-tech.

Portfolio: Why did you start Investors Action Alliance, and what does your group do? Glassman: More and more Americans have been thrust into the realm of investing through 401(k)s and the like without knowing very much about it. There are 100 million small investors in this country now, but they're not well-equipped to make decisions. And they don't have much of a group consciousness when it comes to economic and public policy issues.

Given enough resources, my colleagues and I believe that we can acquire a membership of 20 million people over time. We have a new and beautiful Web site, www.investorsaction.org, and we'll be reaching out with direct mail. We'll do some general investor education, but mainly we're going to focus on public policy issues in Washington and how they affect the value of your investments.

Portfolio: What role can corporate executives play?
Glassman: We'll have a foundation that will mainly be doing investor education and research. Executives may want to support the foundation and that may help them further their own goals. They can get in touch with me directly at jglassman@aei.org.