No. of Recommendations: 8
Wonderful, thought provoking and sobering post, Manlobbi. Thank you. Reminded me of Chris Bloomstran and his 2021 Semper Augustus letter looking at the breakdown of S&P returns for the decade ending 12-31-21. All things rationally considered, he thinks S&P annual expected return will be around 5% over the next decade. Excerpt:
'The largest return driver over the decade was an expansion in the P/E multiple from 13.0 to 23.6 times, an 81.1% increase and annual growth of 6.1%. Here it is important to note that it is not correct to infer that 6.1% of the 16.6% return came from multiple expansion. Remember, the derivation of return is multiplicative. Simply adding across can get close but will not be correct. By attributing each of the five components as a percentage of the return can you then get to a contribution from each. Thus, the index earned 6.4% annually just from multiple expansion alone.
The balance of return was closely split between 3.8% annual growth in the profit margin and 3.7% growth in sales per share. The profit margin grew from what was already a record 9.2% to a new record 13.4%. To get to one of the best 10-year periods of all time, you'd customarily expect to see some combination of margins and multiples rising from a depressed base. A 4% margin and an 8 multiple to earnings in 1982 would be a perfect example here, as that was the launch point for the great 18-year bull market that ensued, when the multiple grew from 8 to 33 and the margin from 4% to 7.4%.
I ask lots of professional investors how fast sales per share and overall dollar sales grew annually for the past decade and two decades. Most guess wildly high. For the past decade, presumed strong by most observers since stocks retuned 16.6%, sales per share grew 3.7% annually, but sales only by 3.0% in dollar terms. A reduction in the overall share count at an annual rate of 0.7% helped the overall return. If one considers that companies spent more than all their profits (augmented with an increase in net debt) not paid as dividends repurchasing shares, perhaps that's what's driven the ballooning of the P/E multiple? This will be seen in reverse when examining the decade ending in 1999 when the share count ballooned, repurchases not yet much of a thing. Either way, executives got rich.
Using very rosy assumptions, an investor concluding that the profit margin at 13.4% will be the peak and the 23.6 multiple (an operating earnings yield of 4.2%) will likewise grow no higher will be left with growth in sales per share plus the dividend yield. Adding 3.7% expected growth in per share sales to today's puny and near-record-low 1.3% dividend yield arrives at a 5.0% annual expected return over the next 10 years.
The CIO expecting a 10% return from the index, presuming sales per share growth of 3.7% and our initial dividend yield of 1.3%, requires some combination of 4.8% annual growth in the margin and the multiple (remember from the formulas above, one must multiply rather than add the growth in sales per share, margin, and multiple). Split evenly, at just less than 2.4% annual growth, the profit margin grows to 16.9 and the P/E multiple to 29.8. Holding the margin at today's peak 13.4% requires a 37.7 P/E multiple. These are bets I wouldn't take, and if the job depends on attaining a return expectation, one really needs to think long and hard about these assumptions.'
