Recently Burgundy’s Chief Investment Officer Richard Rooney stated in our annual client conference call that our equity return expectations for the markets over the next five years are 6-7%. This begs the question: where do return estimations come from? There are three main drivers of future equity returns: earnings multiple expansion, dividend yields and earnings growth.
Earnings Multiple Expansion
Historically, investors have been willing to pay on average 15-16 times earnings for a piece of a company. Therefore, if we consider that “the market” represents an average of companies, and we understand that the companies within the market have generated earnings of $1 per share, then investors have been willing to pay $15-16 per share for those $1 earnings per share. While this is the average, it is worth noting that the price people have been willing to pay for $1 earnings has experienced wide swings in both directions over long periods of time.
An investor’s willingness or hesitation to pay for earnings is the most powerful driver of stock returns over the short term. Holding earnings constant for a two-year period means that if a future investor is willing to pay $20 for $1 of earnings (when you paid $15 for $1 of earnings), then a cumulative return of 25-33% will be earned through multiple expansion. But beware – it works in both directions. If a future investor is willing to pay only $10 for $1 of earnings (when you paid $15 for $1 of earnings), then a cumulative decline of 33-37.5% has been earned.
With that backdrop in mind, where do we stand today? We find ourselves at the historical average, meaning we do not reasonably expect any benefit (i.e., multiple expansion) or detraction (i.e., multiple contraction) in our five-year return estimation.
Over the next five years, we expect a 0% return from earnings multiple expansion.
This is the easiest component to factor into our five-year return estimation. The dividend yield for the average of companies in the S&P 500 Index is approximately 2%, as of September 30, 2013.
Given the strength of corporate balance sheets, we believe these dividends are sustainable. One could argue that dividends will grow from their current payout ratios, but for our conservative estimation we assume that dividends continue to grow at approximately the same rate that they have for the last five years.
Over the next five years, we expect a 2% compounded return from dividends.
The third driver of future equity returns is earnings growth. The S&P 500 Index has grown at 8% over the last five years in a tough economic environment, but it is important to note that most of this growth has come from cutting costs. Essentially, from our vantage point, company managements have exhausted the cost-cutting card.
With margins at all-time highs, we need earnings growth to be driven by top-line revenue growth. In a slower economy, that can be much harder to do. But good, quality companies with sustainable business advantages and fortress-like balance sheets – and there is a higher percentage of those in the S&P 500 than in any other market – should be able to adapt in this new environment and find ways to grow revenue.
Over the next five years, we expect a 4-5% return based on earnings growth.
Summing the Parts
Having worked through the math, let’s return to Richard Rooney’s equity return expectations for the markets over the next five years, which are 6-7%.
Historically, 6-7% isn’t a good return from equities but, given current interest rates, this 6-7% return delivers about the same amount of “real return” (nominal return minus inflation) that the market has delivered for the last 80 years. It would be naive of us to expect that the last two years of 20%+ equity returns will continue, especially – let’s say it again – especially with interest rates at historical lows.
While we know our return estimation is reasonable, we also know that it is likely to be wrong. The good news is that the biggest factor for deviation between expected and actual returns will be what investors are willing to pay for earnings. As mentioned, we know that over the long run investors have been willing to pay 15-16 times earnings, meaning either the positive or negative impact in the short term will eventually revert to a longer-term mean. So, not only is the five-year expected return 0% from this driver, but so is the 10-year expectation and beyond.
At Burgundy we build our portfolios based on quality and valuation; we place the expectation on ourselves to outperform the market in the long term. We are not counting on multiple expansion to enhance our returns over the next five years. Dividends in our portfolio are higher and growing faster than the market, but they alone won’t get the job done. We will also be relying on earnings growth to drive the largest component of our returns. And, in what is expected to be a below-average economic growth environment, we are happy to own higher-quality companies at cheaper prices to help preserve and grow our clients’ capital over the long term.