Dodging Mediocre Retirement Investing

Some general market analysis from Research Affiliates that I completely agree with:

“It doesn’t seem like much to ask for–a 5 percent return. But the odds of making even that on traditional investments in the next 10 years are slim. Research Affiliates looked at the default settings of 11 retirement calculators, robo-advisors, and surveys of institutional investors. Their average annualized long-term expected return? It was 6.2 percent…One message that John West, head of client strategies at Research Affiliates and a co-author of the report, hopes that people will take away is that the high returns of the past came with a price: lower returns in the future.”

Yes. Yes. A thousand times yes.

When you see your net worth in an investment increase by an amount that is greater than the earnings growth and dividend payments borne out by the business, it can only mean one of two things. The investment was undervalued at the initial time of purchase, and now is less so–meaning that future returns are more likely to resemble the business performance itself. Or, it can mean that the investment has become overvalued, and future returns will be less than business results because people eventually come to their senses and reappraise assets.

As we have discussed in the past, my view is that the S&P 500 is beholden to the latter. You cannot value a business growing 6% annually at 24x normalized earnings. That is problematic. It means, at a minimum, you are due for a 20% price decline. When you combine that with single digit growth, you are looking at 4% leftover plus a 2% dividend (i.e. those 6% annual returns.)

John West’s prescription is to focus on maverick risk, which he defines as follows: “The point isn’t to steer people to higher risk. To get higher returns, you have to take on ‘maverick risk’, and that means holding a portfolio that can look very different from those of peers. It’s hard to stick with being wrong and alone in the short term.”

Source: The Next Ten Years Will Be Ugly For Your 401(k)

I agree that being different can be difficult if you measure yourself, or political considerations force you to be measured, based on whether you have been beating the S&P 500 lately.

But if you know what you are doing, you can sidestep the jargon about maverick risk and either own things that trade at a better valuation than the S&P 500 or have superior growth characteristics compared to the S&P 500. This is especially useful if you have access to a brokerage portal with your tax-advantaged investing.

Want better valuation than the S&P 500? Viacom ought to be earning $5.50 per share two years from now (figures which may be temporarily adjusted downward during a CBS merger, but then revised upward thereafter.) That is about 6-7x earnings within two years. It is not difficult to figure out that Viacom ought to be somewhere in the upper $50s right now while the management uncertainty has bid the price of the stock down.

Want better growth than the S&P 500? Nike is earning $2.20 per share right now a valuation of about 23x earnings (it is about 21x earnings on a constant-currency basis.) It has been growing annually at 13% for the past five years, 14% for the past ten, and 18% for the past 25 years. It will probably grow by around 14% for the next five years.

Anyone who is paying attention can see that Nike’s online sales store is absolutely exploding–in the United States, customers have bought 49% more shoes and apparel items at compared to last year. It is only about a tenth of the overall business, but the growth rate is extremely high. The roll-out of Nike stores mixed with a burgeoning online presence even make me question the long-term viability of sporty retailers.

If I had to choose between the two, I would take Nike every time because the investing process requires no additional decisionmaking. If Viacom goes up to $70 or $80, you have to sell it and figure out something else to do. That’s no grave hardship, but if you purchase Nike stock, you can sit back and watch it grow for the rest of your life. It sounds ridiculous, but if Warren Buffett held his less than $10 million investment in Disney back in 1966 to the present day, it would be $12 billion now. Passivity with extreme compounders remains vastly underrated.

I mention all of this to say that there is no reason to be particularly scared about the fact that the S&P 500 is moderately overvalued right now. First, 6% annual return projections are something you can work with if it comes to pass. Also, people with an eye for valuation or earnings growth are now in a position in which their skills will prove most valuable. When the S&P 500 is cheap or fairly valued, it is hard for your skill to show much that is value-added. But when the major indices are overvalued, you can achieve superior results just by exercising ordinary prudence.

Originally posted 2016-10-30 15:07:08.

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