Fundamentals Drive Long-Run Stock Returns
“Market returns are determined by both investment factors—the fundamentals of the initial dividend yield on stocks plus the rate at which their earnings grow—and by speculative factors—the change in the price that investors will pay for each $1 of corporate earnings.”
- Jack Bogle
My investment philosophy is best summarized with one phrase: “Think like a business owner.” It sounds simple enough, but it’s not how the large majority of investors think about common stocks. They prefer to obsess over macroeconomic news and daily stock price fluctuations. It takes work to understand the fundamentals of a business, and discipline to make that the focus of your decision-making.
The total return from a stock (or a portfolio of stocks) is equal to the sum of:
1. Dividend Yield
2. Growth Rate in Earnings Per Share
3. Percentage Change in the Price/Earnings Ratio
4. Compounding Terms between the Prior Items.
Vanguard founder Jack Bogle called #1 and #2 the “fundamental” return, while #3 was the “speculative” return. Shifts in P/E ratios (mostly driven by investor sentiment) can have a disproportionate impact on short-term returns, but they tend to even out in the long run. You can see this in the long-term returns of the S&P 500:
Since 1926, I estimate the S&P 500 has delivered a total return of about 10.2% per year. That can be broken down as 2.3% real (inflation-adjusted) earnings growth, 3.0% annual inflation (nominal earnings grew about 5.3%/year), 0.9% annual P/E expansion (the price return was about 6.2%/year), and 4.0%/year from reinvested dividends. Even though the trailing P/E went from less than 10x to more than 24x, spread over 98 years it amounted to less than 1% per year.
Many investors assume the S&P 500’s historical 10% annual total return is sustainable indefinitely. However, breaking down returns in this way implies reason for caution. First, dividend yields are much lower today than they were in 1926 (about 1.4% vs. 4.8%). Some of that is explained by a lower payout ratio—in which case share repurchases can help make up the difference—but most of it is because of the higher P/E ratio. Second, I wouldn’t count on P/E expansion continuing indefinitely. Starting from current valuation levels, the P/E could easily turn into a headwind. And third, the 3.0% historical inflation rate is above the Federal Reserve’s 2% target (though it’s not far from the 2.8% average of the past 10 years, mostly thanks to the burst of inflation in 2021-22).
The best counterargument would be if real earnings growth accelerates, perhaps boosted by productivity-enhancing technological developments like artificial intelligence. Real earnings growth averaged about 3.9%/year over the past 10 years, or 1.6 percentage points faster than the historical average. Even so, taking all of the above into account, it might be prudent to expect future S&P 500 returns to be at least two to four percentage points below long-term historical averages, or closer to 6% - 8% per year. We can always hope to do better through active management…
Disclosures
Moatiful is an independent publication of Trajan Wealth, L.L.C., an SEC registered investment advisor. The views expressed are solely those of the author, and may not reflect the views of Trajan Wealth. Nothing in this blog is intended as investment advice, nor is it an offer to buy or sell any security. Posts are for entertainment purposes only and should not be relied on when making investment decisions. Please consult your financial advisor for questions about your personal financial situation. All investments involve risk, including the potential for loss. Historical results may not be indicative of future performance. Data from third-party sources is not guaranteed to be accurate, timely, or complete. Links to external sources are provided for convenience only, and do not constitute an endorsement by Trajan Wealth. Clients and employees of Trajan Wealth may have a position in any of the securities mentioned. Data and opinions are subject to change at any time without notice.