Brace Yourself for Mediocre Returns - Part 2, The Equity Edition

While equity markets have more "moving pieces" than their fixed income counterparts, their longer-term outcomes can likewise be broken down into a handful of understandable and forecastable components. When approached in this manner, we see that returns from US and Japanese equity markets in the coming decade are likely to be poor, while returns from the currently "troubled" markets of Europe are likely to be substantially better.

It is a given that there are only two ways to make money from an equity - either you are paid a stream of dividends, or the price another party is willing to pay you for your shares differs from the price you paid (Dividend + Price Change).  In general, the Dividend component is readily observable and tends to be less volatile while stock Price Changes are more volatile and, in the short-run, more unpredictable.

To better understand the portion of return due to Price Change, we can further decompose that piece into Earnings Growth per share and the price one is willing to pay for each dollar's worth of those earnings (i.e. the P/E Ratio).  Both are somewhat volatile, but less so than the overall Price Change itself.  To simplify further, I like to sub-divide the Earnings Growth component into Revenue Growth and the change in the profitability of those Revenues (i.e. the Profit Margin).  Taking all this together then, if we know with certainty just four variables: Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we will know with certainty the return from an equity (or equity index).

Fortunately, two of these components are relatively stable over a period as long as a decade (Dividends and Revenue Growth), while valuation and profitability are more volatile -- and it is this change in Margins and the P/E Ratio that ultimately drives returns.  Thus a sensitivity analysis featuring these two unknowns is called for.

Equity earnings tend to be cyclical over time (see chart) and gauging market value on a single, spot observation can be mis-leading -- especially when earnings are well above, or well below, their trend.  As of June 30th, the P/E Ratio on trailing, reported earnings of the S&P 500 index was 15.5x, below the longer-term norm of 17.0x (the median valuation since Dec 1959).  Based on this, one might conclude that the market is cheaply-valued.  What is left out of such a simplistic analysis is that the earnings part of that calculation is not at the norm, but rather a cyclical high.

Instances such as this tend to occur when margins are well above their norms, even as they are understood to be generally mean-reverting.  Today, S&P 500 margins are near one of these cyclical peaks.  The chart below was first published in my initial blog posting, "The Profitability Illusion" (June 15th), and depicts year-end S&P 500 net margins over the past 15 years.

A longer-term chart using a different set of data, the National Income and Product Accounts from the Bureau of Economic Analysis, which details economy wide profits, delivers much the same message (note how current margins appear to have broken out of their long-term channel.  I showed in "The Profitability Illusion" how this is largely due to the low interest rates engendered by the Fed's QE policies).

Thus, a valuation analysis which adjusts for the margin's deviation from its norm and which assumes dividend growth in line with earnings (as long as the current payout ratio is near longer-term norms), revenue growth in line with historical trends (typically that of nominal GDP) and a valuation component (P/E ratio) that returns to its long-run median over a period of ten-years should provide a decent assessment of where returns are headed as cycles run their course.  Those who disagree with my assumptions of a return to normal margin can use the accompanying sensitivity tables and observe returns under a range of margin and P/E inputs.  However, I would direct doubters back to "The Profitability Illusion" which discusses in some detail why over 2 percentage points of the current S&P 500 margin is illusory and unlikely to be sustained.  In any case, the range of returns can be illuminating and the dispersion of returns, not as wide as one might assume.

I turn first to the United States and use the S&P 500 index as a proxy for US Equities.  Over the past 50+ years, a median valuation of 17.0x earnings is the norm (I choose to use a median as opposed to an average because out-sized values can distort its calculation.  In full disclosure, the average P/E has been 17.6x).  Margins have averaged 6% for the past 50 years and have proven throughout to be mean reverting.  Today, though they stand near record highs of over 8% and in this analysis it is assumed they will slowly return to the 6% average.

 For this exercise, we also assume 5.5% annual compounded nominal revenue growth (in line with historic norms) and a 2.14% annual return from dividends (the current yield).  Putting this all together, our best guess return estimate for US Equities over the next 10 years is 3.9% per year.  If you want to assume record margins continue, you could up that expectation (see table below), but just to 6.8%.  Under no reasonable scenario, are double digit equity returns in sight.

S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.14% Annual Dividend Return, Various Margin and P/E Scenarios)

13x          15x         17x         19x           21x 4.0% -2.8% -1.4% -0.2% 0.9% 1.9% 5.0% -0.6% 0.8% 2.0% 3.1% 4.1% 6.0% 1.2% 2.6% 3.9% 5.0% 6.0% 7.0% 2.7% 4.1% 5.4% 6.6% 7.6% 8.0% 4.1% 5.5% 6.8% 8.0% 9.1%

Taking Japan next we conduct a similar analysis, though using the historically lower 3.0% margin levels and nominal revenue growth.  Though Japanese valuation data is distorted somewhat by 10+ years of a great bubble, we feel a normalized P/E ratio of 20.x, higher than that of the US, can be argued, though we show a range of 12.5x to 27.5x in the sensitivity below.

MSCI Japan 10-Year Return Estimation (3.0% Nominal Revenue Growth, 1.77% Annual Dividend Return, Various Margin and P/E Scenarios)

	12.5x	15.0x	20.0x	25.0x	27.5x
2.0%	-5.7%	-4.0%	-1.2%	0.9%	1.9%
2.5%	-3.6%	-1.9%	0.9%	3.2%	4.2%
3.0%	-1.9%	-0.1%	2.8%	5.0%	6.0%
3.5%	-0.4%	1.4%	4.3%	6.7%	7.7%
4.0%	0.9%	2.8%	5.7%	8.1%	9.1%

Moving on to the European markets and the UK, we reach a somewhat happier, though still below historic, level of return.  For the UK market we use similar revenue (5.5%) and normalized margin assumptions (6.0%) as we do for the US.  For the continent, I discount both revenue growth and margins by 0.5%, in line with historic observations.  Again, under a broad range of valuation and margin assumptions we see the following:

MSCI United Kingdom 10-Year Return Estimation (5.5% Nominal Revenue Growth, 3.95% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
4.0%	0.8%	2.6%	4.1%	5.5%	6.7%
5.0%	3.0%	4.8%	6.4%	7.8%	9.0%
6.0%	4.8%	6.7%	8.3%	9.7%	10.9%
7.0%	6.4%	8.3%	9.9%	11.3%	12.6%
8.0%	7.8%	9.7%	11.3%	12.8%	14.0%

MSCI Europe (ex-UK) 10-Year Return Estimation (5.0% Nominal Revenue Growth, 3.71% Annual Dividend Return, Various Margin and P/E Scenarios)

	10x	12x	14x	16x	18x
3.5%	-0.2%	1.6%	3.1%	4.4%	5.6%
4.5%	2.2%	4.1%	5.6%	7.0%	8.2%
5.5%	4.2%	6.1%	7.7%	9.1%	10.3%
6.5%	5.9%	7.8%	9.4%	10.8%	12.1%
7.5%	7.4%	9.3%	11.0%	12.4%	13.7%

My conclusion is that long-term returns from the major developed equity markets are quite likely to remain in single digits -- and below 5% in both the US and Japan.  This realization, combined with those in Part 1 (which looked at fixed income markets) is that most plan sponsors will have great difficulty achieving their projected return assumptions, even under the most optimistic of market conditions.  Obviously a new perspective on managing funds is called for.  In coming posts, I will make some suggestions.


Sources Used: Bloomberg, Zack's Research System, Bureau of Economic Analysis, MSCI Barra, Brett Gallagher

The Profitability Illusion

The current near-record level profit margins of the S&P 500 are largely an illusion, created solely by the fact that interest costs have fallen precipitously, even as overall debt levels have increased.  Operating profitability, is actually below average.  As the Fed’s Quantitative Easing program is unwound, earnings are at significant risk

Current profit margins for S&P 500 companies remain near historic highs even as the broader economy struggles and real income growth remains anemic.  The stock market trades near record levels supported, if not by fundamentals, by promises of the Fed to hold interest rates near historic lows.  Today though, the certainty of those promises is being discussed with potentially very negative consequences for US and Foreign Markets.

Market bulls point to high profitability and supportive market action as well as benign valuation as reason for their continued positive stance.  Indeed, market participants are by many measures, as bullish as ever (hedge fund net longs, investor sentiment measures).

However, analysts, like myself, who believe that margins tend to be cyclical in nature, caution that today’s high margins are a reason for restraint, not celebration.  Traditional valuation metrics like P/E ratios, tend to understate the valuation of markets when margins are well above average, as they are today, leaving open to question whether the factors supporting the market are capable of remaining in place for an extended period.

Bulls will counter that we have witnessed a permanent shift upward in margins given the now global nature of production and the ability of corporations to manage costs better than ever by using offshore operations when beneficial.  This same argument is often cited when explaining why US personal income growth remains anemic.  While on the surface this is a believable narrative, the data does not back it up.

When margins are decomposed into their component parts:

• ·         operational factors (sales less the direct costs of production)
• ·         tax factors (the percentage of sales one forfeits in taxes) 
• ·         financing factors (amounts paid due to corporate financing decisions), and
• ·         extra-ordinary items (one-off items, not likely to be recurring in nature)

it becomes obvious that the historic profitability of the S&P 500 today relies solely on the fact that interest costs have fallen precipitously during the Fed’s period of QE even as overall debt levels have increased.

Current net margins are quite high by historical standards (8.04% versus the 15-year average 6.55%).  However, “operational margins” (the profitability of a company apart from their taxes and financing decisions) are now actually below average – so much for the benefits of global production.  The reason for the discrepancy between margins as generally discussed and operational factors has to do with the very low level of interest expense (1.78% of S&P 500 sales compared to an average of 3.88%), even though overall leverage (debt as % assets) has risen to 14.2% from the long-term average of 11.5% (Averages use year-end figures calculated from Dec 1998 through Dec 2012).

The charts which follow demonstrate this dynamic quite clearly.  After a bump during the period 2005 – 2007, interest expenses have fallen dramatically in spite of the fact that debt levels climbed (most precipitously in 2009).  To measure leverage, I have chosen to show both Total Debt to Asset as well as Net Debt to Asset measures.  It is my belief that net debt better hints at corporate vulnerability to leverage as it takes into account “tactical” debt issuance where retained cash can, theoretically, be used to immediately reduce leverage should borrowing costs reverse).

The chart below shows “operational margin” levels since 1998.  Current readings are slightly below average.  Should interest costs rise and encroach on overall business profitability, it is net margins that will have to suffer disproportionately.

Sources for all exhibits: Brett Gallagher, Zack’s Investment Research

Two conclusions can be drawn from the above.  First, given the low level of interest rates, further progress in margin enhancement via lowering interest expense without paying down debt would seem limited and operational metrics must improve if current margins are to be sustained.

Secondly, should rates reverse their downward trend, interest costs could have the opposite effect on profitability as financing costs rise dramatically.  If interest expenses revert to their historic average, net margins would fall below 6% (all else equal, this results in a 25% earnings decline from today’s levels).

IN CONCLUSION, assuming continued sluggishness in economic (and, hence sales) growth, high levels of leverage and a bottoming of interest rates, maintaining margins above the norm is unlikely and reversion to mean becomes a more likely outcome than a secularly higher level of profitability.  In such an environment, earnings are vulnerable as are P/E multiples, meaning equities themselves are at risk. 

In the next two postings to this blog, I will provide long-term return assumptions for US, UK, Continental European and Japanese equities (under a range of margin and P/E assumptions) as well as a variety of government and corporate bond markets using a proven valuation methodology.  The results will have significant implications for plan sponsors and other investors.