The Four Drivers of Long Term Equity Returns

As a stock picker I’m investing to beat the market over the long term.  Of course by ‘beat’ the market I mean that the value of my portfolio goes up more than the value of the market, including re-invested dividends.

But where will these gains come from?  If my Vodafone shares are worth £1.70 each today, why would they be worth any more in the future?

There have been various studies into this and generally they cite four major drivers, which are:

Inflation

Everybody hates inflation, but as prices go up the value of companies go up with them – not exactly, but more or less.  This is because inflation causes expenses to go up, but it also causes income to go up.  Studies show that over the long term equities go up roughly in line with inflation.

This is interesting but from my point of view not that helpful since I can’t control inflation.

However, I can keep an eye on the companies I buy and try to pick those that will be able to increase their prices in line with inflation.

Real earnings growth

This is earnings growth with inflation taken out (otherwise I’d be double counting inflation).  Real earnings growth is the growth that comes as companies get bigger, which is possible due to the expansion of the economy, increases in population and other similar factors.

History shows that earnings growth has been quite steady over the years as we keep adding new people and new technologies and markets to the planet.

Where does this real growth come from?

In simple terms, it comes from companies reinvesting retained earnings.  Each year a company might earn say £100million and they pay £40million out to shareholders as a dividend (which I’ll get to in a minute).  The remaining £60million they keep in the company and invest into new factories, new products or something else, in order to grow the company’s future earnings.

If that retained £60million goes into a new factory which generates £30million in profits the following year, then the management of the company have got a fifty percent return on that invested capital.  So now the company is earning £130million instead of £100million, i.e. it has grown by profitably reinvesting retained earnings.

This is of interest to me because different companies generate different rates of return on their retained earnings.  Some return 50%, some return very little or nothing.

Over the long term the companies that make up the FTSE 100 have returned about ten percent on their retained earnings.  That’s made up of some companies that return more and other that return less.

I think that by focusing on companies that return more on their retained earnings than average – and grow consistently as a result – I can maximise this driver of long term returns.

Changes in valuation ratios

Over long periods of time measures of value like the price to earnings ratio (PE) hover around some average figure, both for the market and for long established companies.

When these ratios are low, the price is typically low and more likely to increase.  When the ratio is high, the price is typically high and more likely to decrease.  In other words, they are mean reverting.

For example, between 1993 and 2000, the FTSE 100 PE ratio went from about 16 up to 27.  Then from 2000 to 2009 it went from 27 down to about 9.  In this time the index’s earnings went from about 175 index points to 270 and then up to 500.  The earnings don’t go up in a straight line, but they don’t move around anything like as much as the PE ratio either.

In the case of the FTSE 100, the PE ratio seems to be hovering around a long term average in the low teens.

A better way to predict PE mean reversion (and so the likely direction of change in these valuation metrics) is to use PE10, or the current price compared to the ten year earnings average.  This makes the E part of the ratio more stable and predictable.

Robert Shiller, the Professor of Economics at Yale, has gathered data on PE10 for the United States and it shows that for over a century the ratio has swung around an average of 16.

The PE10 can be seen as a measure of investor sentiment.  When everyone is happy they expect future returns to be high and so they are willing to get fewer returns on their money today in order to buy into those greater returns tomorrow.

The amount of returns they get today is the inverse of the PE, which is the earnings yield.  The lower the PE the higher the earnings yield, which is like the interest yield on a bank account – more is better.

The same principle can be used with individual companies.  Assuming I’m looking at a company which is very stable and has a long history of profit, I can use the PE10 to gauge how ‘cheap’ or ‘expensive’ the company currently is and how likely it is that I’ll be able to gain from PE10 mean reversion.

By focusing on low PE10 companies I may be able to profit from positive PE mean reversion, i.e. an increase in the PE or PE10 ratio over time.

Dividends

It’s a surprise to many that dividends are a key part of investment returns.  A lot of people just think investing is about capital gains when the latest hot stock doubles overnight, and that bonds or savings are for income.

Nothing could be further from the truth.

For example, the 2011 Barclay’s Equity Gilt Study showed that £100 invested in equities in 1899 would have grown to £12,655 if dividends had been withdrawn.  If dividends had been reinvested then the investment would have grown to £1,697,204.  Dividends increased the gains tenfold (and in real terms the gains were a staggering 300 times better).

Dividends are that part of corporate earnings which are paid out to you, and it’s your job to decide how to invest them.  So it’s possible to look at earnings as being split into two parts:

The first part is retained by the company and reinvested in either well or poorly, depending on the rate of return that management can get.

This is where Warren Buffett has an advantage in that he can tell his managers that they should only retain earnings if they can get a 15% annual return on them.  Otherwise they should be paid to Buffett and he can look for somewhere to invest those earnings at a higher rate.

The second part is paid to you as the dividend and that’s the bit where you get to play Buffett’s role.

If you want to invest them in a flash car (I used to own a Jaguar XK8 – it was a nice car but not a good investment) then that’s up to you.  But as the equity gilt shows, if you withdraw dividends from the portfolio then their effective rate of return is minus 100 percent, and that’s a big drag on future growth.

I can benefit from this long term driver by demanding a relatively high dividend yield and reinvesting the dividends as well as I can (and not spending them on frivolity).

Which is the most important factor?

Historically it has been mean reversion of valuation ratios like price to book and price to earnings which have had the greatest effect on long term equity returns.  Not because they generate any long term return on their own, but because they are volatile and revert to the mean either positively or negatively.

If you bought shares in 2000, even though earnings and dividends increased over the following decade – much like they have in the past – your returns were massively hampered due to the negative mean reversion of valuation ratios.

However, not everyone focuses on valuations by trying to buy when they are low in order to capture their positive mean reversion.  That, of course, is the main focus of value investors.

Growth investors focus instead on trying to maximise the earnings growth aspect of long term returns.

Income investors on the other hand, focus on the dividend as their main driver of returns.

I think the best investment policy is one that focuses on all these factors at the same time.