What drives corporate profits over time and how do they contribute to long-term stock returns.
In this episode you’ll learn:
- What drove U.S. stock returns over the past thirty years.
- How long-term corporate profit growth has tracked per capita GDP growth.
- What contributes to long-term corporate profit growth
- What are the things corporates can do with their cash.
Why U.S. Stock Returns Will Be Lower
Over the past thirty calendar years from 1985 through 2015, the U.S. stock market as measured by the S&P 500 Index returned 10.4% annualized on a nominal basis and 7.8% after adjusting for inflation.
Those are remarkably good returns, and if they were repeated over the next thirty years, then that would go a long way in helping individuals save enough for retirement.
Equity Building Blocks
To see if those returns are repeatable, we can decompose them into the three building blocks that drove performance: dividends, corporate earnings growth and changes in valuation.
Dividends represent corporate earnings that companies pay out to shareholders. Over the past thirty years, dividends represented 3% points of the S&P 500 Index’s annualized total return according to data prepared by Research Affiliates, an investment management and research firm.
Nominal corporate earnings growth represented 4.6% points of the S&P 500 Index return over the past thirty years.
If investors had been willing to pay the same multiple of earnings in December 2015 as they did in December 1985, then U.S. stocks would have returned 7.6% annualized on a nominal basis over the past thirty years (i.e. 3% dividends + 4.6% earnings growth).
Instead, investors increased the amount they were willing to pay for each dollar’s worth of earnings. In 1985, investors valued U.S. stocks at approximately 11 times the previous year’s earnings, which equates to a price-to-earnings (“P/E”) ratio for the S&P 500 Index of 11.
At year-end 2015, the U.S. P/E ratio was close to 20. The near doubling of U.S. stock market valuations was a significant contributor to stock market returns over the past three decades as 2.8% points of the S&P 500 Index return was because stocks became more expensive.
Now that we know what drove historical stock returns, what annualized return can we anticipate for U.S. stocks over the next decade?
We can again look at the three building blocks.
Is it reasonable to assume investors will pay more for stocks ten years from now then today given current high valuations? Probably not. If anything, stock valuations might fall, which could be a drag on returns.
Let’s keep things simple and assume valuations will stay the same and overall annualized returns for stocks over the next decade will be driven by dividends and earnings growth.
The dividend component is fairly straightforward. The S&P 500 Index dividend yield is currently 2.1%. This suggests dividends will contribute approximately 2.1% point to U.S. stock returns over the next decade.
The next building block is expected corporate earnings growth. Over the long-term, annual real (i.e. net of inflation) corporate earnings growth per share has tended to track real per capita gross domestic product (“GDP”) growth.
From Q4 1985 through the start of the Great Recession at the beginning of 2008 real per capita GDP growth was 2% annualized, at a level that contributed to robust corporate profit growth.
But since the end of the recession in Q2 2009, real per capita GDP has grown only 1.3% annualized, much slower than previous economic recoveries.
Corporate earnings growth from year-to-year can be quite volatile as earnings tend to collapse during economic recessions then rebound sharply.
Since the end of the Great Recession, nominal S&P 500 earnings have grown at a 12% annualized rate according to FactSet, but has slowed markedly over the past couple of years.
FactSet reports overall S&P 500 earnings grew only 0.5% in calendar year 2015 compared to 2014. On a per share basis, S&P 500 earnings in Q4 2015 declined 4.2% from Q4 2014.
While much of the earnings decline can be attributed to falling oil prices as energy company earnings got crushed, only three out of ten S&P 500 Index sectors posted positive earnings growth in the fourth quarter: telecom, healthcare and consumer discretionary.
So with U.S. corporate earnings growth stagnating after posting double digit annualized gains coming out of the recession and with overall economic growth as measured by per capita GDP sub par, what is a reasonable estimate for U.S. corporate earnings growth over the next decade?
If corporate earnings grow in the decade ahead at a similar pace as they did the past thirty years then investors can expect a 6.7% annualized return for U.S. stocks (2.1% dividends + 4.6% earnings growth). This assumes stock valuations stay at a price-to-earnings ratio of around 20. If the P/E falls, then returns will be lower.
If real corporate earnings grow at 1.3% per year, the level per capita GDP has grown since the recession, then overall U.S. stock returns would be 6% annualized, assuming an inflation rate of 2.6% (2.1% dividends + 1.3% real corporate earnings + 2.6% inflation = 6.0%).
This again assumes U.S. stock valuations stay close to where they are at present. If valuations fall, then U.S. will return less than 6%.
Expected annualized returns for U.S. stocks over the next decade of 6% to 6.7% with risks to downside if valuations fall is well below the U.S. stock market’s 10.4% annualized return over the past thirty years.
With bond yields also low, workers will need to save a higher percentage of their income than in the past in order to offset lower expected returns for stocks and bonds.