A great quote from Leon Cooperman, the founder of the hedge fund Omega Advisors: “I am very knowledgeable and cognizant of what the S&P 500 represents; in 2015, it is an index of 500 companies, on average they are growing about five percent a year, and they yield about two percent, and they trade a little under three times their book value. They have got 35 or 36 percent of debt in their capital structure, and for those financial statistics you pay on average about 18x this year’s earnings. So, as a value investor, I look for either more growth, a lower multiple, or more asset value possibly mixed with more income yield. I want some combination that says Buy Me. My team and I spend all day long, seven days a week, 24/7 trying to look for things that are mispriced in the market.”
The S&P 500 is up to 502 companies right now, but Cooperman’s summary is a useful analysis point to understand John Bogle’s prediction that the S&P 500 should deliver 6% to 7% annual returns from 2015 through 2025 if the general stock market is fairly valued in 2025 (e.g. if 2025 valuations are like 2004 or 2012).
I’ll never forget watching Donald Yacktman giving his “Investments, Values, and Ethics” speech at Texas Lutheran University in which he mentioned that rising stock prices are useful final vindications that you are finally making money from your investment, but come with the corresponding truth that future returns will be diminished as a result of the lower price (in other words, someone who buys Visa at $50 per share will always end up with more aggregate wealth than someone who pays $75 per share).
That warning from Yacktman is useful to keep in mind when we are in the seventh year of one of America’s strongest bull markets in the past two centuries. If you are someone who has held some stock market investments since 2009, this has been a generally good period for you if you owned typically performing American stocks. People buy-and-hold stocks because they expect a payoff at some point in time, and the performance between 2009 and 2015 has delivered: if you have stuck around, you have gotten your payoff.
But it also means that, as prices rise, forward projections will diminish. Companies that stripped themselves down to keep profits high and keep the dividends flowing had cut to the bone during the Recession, and this has created unusually high profit margins that will be hard to maintain (to read an excellent article on why I may be wrong about this aspect of the prediction, click here to see National Financial’s excellent discussion “U.S. Corporate Earnings: Are Current Profit Margins Sustainable?”).
My argument’s premise is that net profit margins, which set at 11.4%, is still only two years removed from 2013’s figure of 12.7% that was the highest since 1950. Unusually high profit margins generally arrive during economic expansions that have followed difficult economies that required significant cost-cutting. Other than a strong U.S. dollar, there is nothing meaningful weighing on the earnings per share figures that corporate America is currently reporting.
A company tends to have three options when growing profits. It can repurchase shares, raise profit margins, and sell more stuff (top-line growth). The effectiveness of share repurchases are contingent upon valuations, and profit margins would need another round of technological gains to advance. WIth an expected future reliance on revenue growth to fuel earnings growth, I would not be expecting historically above-average earnings per share growth from the S&P 500 during the 2015 through 2025 measurement period.
That leaves us with valuation. S&P 500 stocks may be 20% overvalued on a historical P/E basis, but I would be willing to lower that to 15% due to the effects of the strong dollar that is mildly depressing the overall earnings picture of the 502 companies as a whole. Counting dividends, we should be expecting about 6-7% annual returns from 2015-2025 compared to the near 10% annual returns that a basket of U.S. stocks generated from 1926 through 2012.
There are two conditions that can be difficult in which to make investments. The first is during scenarios like 2008-2009, when investors must ignore recency bias and declines in their own net worth to continue reinvesting and apply fresh cash to attractive opportunities. Under this scenario, the difficulty is entirely psychological: You must convince yourself that now is the right time to buy.
During 2015 conditions, the difficulty is quite different. Many investors seem quite willing to buy, but the difficult point is figuring out what to buy. Leon Cooperman puts it well. To get returns equal to the 10% that we historically expect, we either need to find companies trading at cheap valuations that offer equal growth to the S&P 500 as a whole, or we need to find companies with superior growth than the S&P 500 where the growth projections exceed any valuation premium between the stock and a typical S&P 500 company.
My preferred response? Go British. Look to the likes of BP, BHP Billiton, GlaxoSmithKline, and Diageo. The first two have much favorable valuations compared to the S&P 500, Glaxo has a bit better valuation and better total return prospects when considering the dividend, and Diageo is one of those opportunities to buy a “wonderful company at a fair price” as you get a high probability of 3% dividends and 8% earnings per share growth from one of the best companies in the alcohol sector.
The other alternative is to remain in America and look at great companies with beaten down valuations like Exxon and Chevron, or try to figure out whether the valuation premium of companies like Visa and Nike will still lead to market-beating returns because the earnings growth may prove superior to the eventual P/E compression so that overpaying for those companies still ends up beating the S&P 500. The latter strategy comes with greater risk of justified capital impairment if earnings disappoint, but it can still end up beating the Chevron and Exxon examples if you are dead right (look at the riches created by paying a high premium for Starbucks in the late 1990s).
Truly lucrative investing is about trying to find a favorable relationship between minimal capital deployed and outsized returns generated by compounding. My guess is that people investing in S&P 500 Index funds today will see $100 turn into $180-$200 within ten years. That is the kind of thing that will help you move forward, and increase purchasing power, but it is not a ripe situation for creating gaping strides in your financial situation.
Bogle puts it well, implicitly suggesting that investors will be mildly disappointed with their investment returns over the next ten years when compared to historical results. And Cooperman’s characterization explains why that is the case, and provides a thought process that can aid in trying to achieve gains in the 10% range. Looking for high-caliber companies that are cheaper than the S&P 500 due to temporary problems, or finding companies with high probabilities of superior growth and only modest premiums seems to be the best way of getting there.
The good news is that it only takes one investment opportunity to occupy your fresh cash, and it is certainly doable to find companies that will get you to that 10% point. The S&P 500 may not do it from 2015-2025, but the few gems at fair prices out there like Diageo are all that it takes to keep you moving forward at a jogging rather than power-walking pace.