June 30, 2017

 

Dear Investor:

In the short term, markets react to nearly everything—or to nothing at all. In the long term, only one thing matters: the growth rate of earnings, relative to interest rates and the price paid.

Traders, pundits and speculators waste their time trying to predict things like political machinations, macro themes and Federal Reserve policy. These things are unknowable. The investor, by contrast, buys good businesses at decent prices and holds them until they are overvalued. As Berkshire Hathaway’s Charlie Munger said at the most recent shareholder meeting, “A lot of other people are trying to be brilliant. We’re just trying to be rational.”

In the spirit of the rational, let’s look at the expected returns on two major asset classes: U.S. stocks and emerging market stocks. Of course, no return is guaranteed or assured (that’s the meaning of “expected,” after all), but we can still make some logical estimates.

The expected return of any stock is its current dividend yield plus its estimated earnings growth rate plus (or minus) its degree of variance from its intrinsic value:

EXPECTED RETURN = DIVIDEND YIELD + EARNINGS GROWTH RATE +/- VARIANCE FROM INTRINSIC VALUE

For example, U.S. stocks (as measured by the S&P 500 Index ETF) are currently trading with a dividend yield of 1.87%. Extrapolating the historical trailing average, the expected earnings growth rate on these companies is 6%–9%, or an average of 7.5%.

If we add the dividend yield and the expected growth rate of earnings, we get 9.37%:

1.87% + 7.50% = 9.37%.

This is the future expected annual return you could anticipate if stocks were fairly valued. But if we agree U.S. stocks are overvalued, we have to amortize the penalty for overvaluation over our expected investment period, usually 5–10 years. Trading at 20 times forward earnings, stocks are overvalued by approximately 20% (adjusted for interest rates). This implies some drag on returns—anywhere from perhaps 2.20% to 4.35% over the investment period. If the valuation corrects itself over ten years (a decent historical assumption), the 9.37% return will lose 2.20% per year to the drag from overvaluation:

9.37% – 2.20% = 7.17%

Given the fact that expected returns are better quoted in ranges than in exact terms (as Buffett always says, “I’d rather be approximately right than precisely wrong”), we can, therefore, estimate that U.S. stocks will deliver 6%–8% annually over the next decade—better than bonds but nothing to get excited about.

On the other hand, emerging markets (as defined by the Schwab Emerging Markets ETF) have a 2.29% current dividend yield, a long-term earnings growth rate of 10%–12%, and are trading at 12.86 times future earnings (a 20% undervaluation to the historical average of approximately 16 times earnings). If we add those together and then adjust for the tailwind of undervaluation by amortizing 20% over ten years (2.20% per year), we get 15.49%:

2.29% + 11.00% = 13.29%

13.29% + 2.20% = 15.49%

The estimated range of expected annualized returns on the Schwab Emerging Markets ETF over the next decade would thus be around 15.49%, or a range between 12% and 19%, double the expected return on the S&P 500. Is this a foregone conclusion? No. Can it be guaranteed? No way. Is it a better guide to your investment strategy over the next ten years than reading tea leaves, the zodiac or the Wall Street Journal? Most likely.

Expect a very rough ride as well. Stocks have not seen a bear market in eight years. Before they go up, they are more likely to go way down. None of that should affect the future expected rate of returns on stocks, both at home and abroad. And here’s to being rational, not brilliant.

With best wishes for the coming quarter.