It's All in the Math - Equity Returns over the Coming Decade (2 of 2)

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 disciplined manner, we see that returns from nearly every major equity region in the coming decade will be poor, with the UK faring better than most and the US likely to struggle.  

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 P/E Ratio (i.e. the price one is willing to pay for each dollar's worth of those earnings).  Both are somewhat volatile, but less so than the overall Price Change itself.  To simplify further, I 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 near certainty just four variables: Dividends, Revenue Growth, Profit Margins and the P/E Ratio, we know with certainty the return from an equity (or equity index).

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

 

Some Background

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 18.2x, just above the longer-term norm of 17.1x (the median valuation since Dec 1959).  One might therefore conclude that the market is slightly overvalued. What is left out of such a simplistic analysis is that the earnings part of that calculation is not at its norm, but rather closer to a cyclical high.

 

 

 

 

 

 

 

 

 

 

 

Instances such as this occur when margins are historically high, even as they are understood to be generally mean-reverting.  Today, margins in the US and Japan are closer to one of these cyclical peaks, while those in the UK and Europe are not.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

When valuation is compared to reported earnings per share, and the cycle is not taken into account, valuation (as measured by the PE Ratio) tends to be more volatile.  When the index price level is measured against trend EPS (that is, assuming a constant "normalized" margin), valuation extremes tend to disappear and a more stable relationship is observed.

 

 

 

 

 

 

 

 

 

 

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 - but refer to the above charts to understand what is in the "normal" (i.e. likely) range of outcomes.  I would direct doubters back to "The Profitability Illusion" (posted to this blog June 15, 2013) which discusses in some detail why over 2 percentage points of the current S&P 500 margin is illusory and unlikely to be sustained (all due to lower interest expense as opposed to better operational efficiency).  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 17.1x 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 2.08% annual return from dividends (normalized current yield). Putting this all together, our best guess return estimate for US Equities over the next 10 years is 2.0% per year.  If you want to assume record margins continue, you could up that expectation, but just to 5.0% (see table below). Under no reasonable scenario, are double digit equity returns in sight.

 

S&P 500 10-Year Return Estimation (5.5% Nominal Revenue Growth, 2.08% Annual Dividend, Various Margin and P/E Scenarios

		Normalized PE Ratio
	2.0%	13	15	17	19	21
Normalized Margin	4.0%	-4.5%	-3.1%	-1.9%	-0.9%	0.1%
	5.0%	-2.4%	-1.0%	0.2%	1.3%	2.3%
	6.0%	-0.6%	0.8%	2.0%	3.2%	4.2%
	7.0%	0.9%	2.3%	3.6%	4.7%	5.8%
	8.0%	2.2%	3.7%	5.0%	6.1%	7.2%

 

Taking Japan next we conduct a similar analysis, using the historically lower 3.0% margin levels and 3.0% 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.  Still, a 3.0% return is the most likely annual outcome for the coming decade.

 

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

		Normalized PE Ratio
	3.0%	12.5	15.0	20.0	25.0	27.5
Normalized Margin	2.0%	-5.4%	-3.7%	-1.0%	1.2%	2.2%
	2.5%	-3.3%	-1.6%	1.2%	3.5%	4.4%
	3.0%	-1.6%	0.2%	3.0%	5.3%	6.3%
	3.5%	-0.1%	1.7%	4.6%	6.9%	7.9%
	4.0%	1.2%	3.0%	6.0%	8.3%	9.4%

 

Moving on to the European markets and the UK, we reach a somewhat happier, though still below historic, level of return expectations.  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 a most likely return for the UK of 5.7% and a most likely return of 3.9% for the continent.

 

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

		Normalized PE Ratio
	5.5%	10	12	14	16	18
Normalized Margin	4.0%	-1.7%	0.1%	1.6%	2.9%	4.1%
	5.0%	0.5%	2.3%	3.8%	5.2%	6.4%
	6.0%	2.3%	4.1%	5.7%	7.1%	8.3%
	7.0%	3.8%	5.7%	7.3%	8.7%	10.0%
	8.0%	5.2%	7.1%	8.7%	10.1%	11.4%

 

 

 

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

		Normalized PE Ratio
	4.0%	10	12	14	16	18
Normalized Margin	3.5%	-3.8%	-2.1%	-0.6%	0.7%	1.9%
	4.5%	-1.4%	0.3%	1.9%	3.2%	4.4%
	5.5%	0.5%	2.3%	3.9%	5.3%	6.5%
	6.5%	2.2%	4.0%	5.6%	7.0%	8.2%
	7.5%	3.6%	5.5%	7.1%	8.5%	9.7%

 

 

CONCLUSION

It is almost certain that returns from the major developed equity markets are quite likely to remain in single digits - from somewhere near 2.0% compounded in the US to under 6% compounded in the UK – for the decade ahead. This realization, combined with similar fixed income expectations is that most plan sponsors will have great difficulty achieving their projected return assumptions of over 7.5%, even under the most optimistic of market conditions

Obviously a new perspective on managing and allocating funds is called for. This is why my July blog post, “The Task of Capital Allocators” is so important for every Plan Sponsor to consider.

 

 

It's the Great Rotation, Charlie Brown

In the 1966 animated movie, “It’s the Great Pumpkin, Charlie Brown”, Linus van Pelt sits in the pumpkin patch on Halloween evening, waiting for the Great Pumpkin to arrive while his friends trick or treat from door to door gathering candy and popcorn balls.  Unfortunately, for Linus, the Great Pumpkin never shows.

Today, there’s lots of talk about “The Great Rotation” – an idea that as the economy recovers, rates will rise, investors will abandon bonds and equities will soar based on a better economy and better earnings.  Like Linus, investors who believe in this real world coming, will be disappointed.

Over the past year, the S&P 500 is up by more than 20% while earnings per share have climbed only 4.2% (even less excluding financial stocks).  Thus, investors have already been factoring in improvement into their willingness to pay more for each dollar’s worth of today’s earnings.

The flaw in their thinking is twofold:   

• First, stocks tend to do better when rates are falling, than when they are rising
• Secondly, there are two “components” to earnings – operating and financing, and rising rates will dramatically challenge the second of these

When we think of how a company works, we assume without much afterthought, that it does better when the economy does better.  However, let’s examine this a little bit more.

A company makes its widgets, or provides a service, which they sell for a certain amount.  However, there was a cost to manufacturing and selling that widget or service – materials, electricity, labor, marketing, etc.  The difference between these costs and the sales price is the operating profit – or what we think of as “the business”.

There is, however, a second, less considered component to earnings, and that is the financial component.  In order to make their widgets, the company had to invest in plant, property and equipment.  Usually, they will have to sell equity or borrow money to fund this investment.  Whether they choose to issue equity or bonds, borrow from the bank, set the term of the borrowing, etc. is a financial decision every bit as important as the decisions made in manufacturing its product.

Over the past few years, many companies reacted to the Fed's decision to artificially lower interest rates (Quantitative Easing) by borrowing to fund their investments.  As evidence of this, we can see how debt outstanding as a percentage of assets has risen since QE was introduced in 2008.

Even when accounting for the cash that has built up on balance sheets (borrowing for future purposes), leverage has still increased.  This is most clearly see if we subtract cash retained on the balance sheet from the total debt amount (giving us Net Debt) and express that as a percent of assets.  Such an exercise shows a rise in leverage over recent years to 14.2% of assets (from a 15-year average of 11.5% and a 2008, pre-QE low of 7.1%)

Interestingly, however, the overall cost of this borrowing has not grown, even as the amount borrowed has.  At the end of 2012, interest expense fell to 1.78% of sales from a 15-year average of 3.88% (and note it had never been below even 3% of sales until 2009).

So let’s say a company sells it widget for $100, and its cost of materials, labor, etc was $90.  Then their operating, or business, margin is 10 cents on the dollar.  Now, let’s subtract the costs of borrowing, currently 1.78 cents.  So the bottom line profits are 8.2 cents for every dollar of goods sold.  If, however, the cost of borrowing were closer to “normal” (3.88% of sales), the bottom line would be more like 6.1 cents.  In other words, you could expect earnings to fall roughly 25% even though the “business” environment hasn’t changed at all.

Yet another aspect of financial management relating to the low rate environment engendered by QE is the option many companies have followed to borrow at low interest rates for the purpose of buying back stock.  Remember, there are two ways to grow EPS, grow the earnings or shrink the number of shares.  Buoyed by QE, companies have opted to buy back shares, allowing EPS to grow faster than earnings overall (in some instances, outright earnings declines have been “converted” into EPS gains through a shrinkage of the share base). 

For the market as a whole (the S&P 500 index), In each of the past five years, operating income per share, has grown faster than overall operating income – evidence of a share base shrinkage (A positive numbers in the chart below indicate share buy backs.  A negative number, share issuance).  As rates rise, this practice of borrowing to repurchase shares will diminish and the ability to manufacture EPS growth will be further challenged.

Prima facie evidence that such financial machinations are still alive and well, surfaced earlier this week when Carl Icahn tweeted about acquiring a large stake in Apple Computer.  Icahn stated that Apple didn’t even need to grow its business for its share price to climb from $525 to $625 per share - they could simply borrow money at 3% and buyback shares that were more dear.  So whilst this financial maneuver is still viable, investors will be pressed to continue it should the cost of borrowing climb. 

In simple terms, any rise in interest rates will bring an end to the ability companies have had to manage the financial component of their businesses, even as the economy improves and helps their operating business.

There is one final element to managing the “financial” component of earnings that has nothing to do with interest rates.  It has to do with taxes.   As tax rates have come down over the years and as US companies do more business in lower tax jurisdictions, the effective taxes they have paid have fallen.  In other words, they get to keep more of the money they earned – another boost to the “non-business” side of earnings. 

Looked at from an economy-wide perspective (using the National Income and Product Account data from the US Bureau of Economic Analysis), the effective tax rate paid by US companies has fallen dramatically, especially in the past decade.  For the most recent 12 months, companies have paid out a little more than 18% of their earnings as taxes.  That’s down from a 50-year average of roughly 34% - a reduction of almost 50%.  To put this into some perspective.  If today’s effective tax rate of 18% were to return to the 25% rate which was the norm as recently as 2002 – 2006, the net margin would decline from 8.1% to 7.4% – corresponding to an earnings decline of just over 8.5%.

Unlike interest expense and share buybacks, I don’t necessarily think this is a trend that is going to reverse soon, but by the same token, I don’t see much room for improvement, especially as debt-laden Governments, worldwide, look to increase their revenue base.

So Linus and equity bulls, whilst I admire your faith and convictions, evidence would seem to be against the arrival of The Great Rotation.