Quarterly Letter to Clients - January 2016
Historical investment results have shown the clear-cut long-run advantage of holding common stocks versus other types of securities. Since 1926, large-capitalization stocks, as measured by the Standard & Poor’s 500 Index, have averaged total returns of 10.0% per year, from price gains plus dividends, and small-capitalization stocks, as calculated by Ibbotson Associates, 12.0%. These figures are well above the 6.1% return from long-term corporate bonds and 3.4% from Treasury bills in the same period. As could be expected, year-to-year returns from stocks have varied much more than those from fixed income securities, and for the Standard and Poor’s 500 stocks, have actually been negative in 24 of the 90 years of this long period. Staying with stock investments through markets good and bad has been very helpful, however. Only 3 of the 81 possible ten-year holding periods ending December 31 since 1926 have had negative returns, and none of the twenty-year periods. Conclusion: If your financial requirements and mental fortitude are such, invest at least a portion of assets in common stocks, and if you can, stay the course for a number of years. Attempts to time the market seem doomed to failure, and being out of the market when prices boom, even for short periods, can also take results well below the figures noted above.
Conventional wisdom has emphasized the importance of corporate earnings and dividends as determinants of stock prices. Much of Wall Street’s research has this focus, projecting a company’s earnings into the future before applying a valuation multiple to estimate likely gains. When one looks at stock prices year to year, however, whether of individual securities or major indexes, changes in price/earnings valuation often play a larger role than changes in earnings. In the 1980s and ‘90s, for example, stock investors were rewarded with outstanding results, total annual returns of 17.6% and 18.2% respectively in the Standard and Poor’s 500 Index. Earnings were strong in those twenty years, increasing 244% for companies in the Index, but the biggest impact for such high total returns was a 301% jump in the average price/earnings ratio of companies in the Index, from 7.4 all the way up to 29.3. While earnings growth was impressive, investor valuation of those earnings was the biggest factor fueling the increase in stock prices.
Corporate earnings, particularly in summary form in a major index, are surprisingly stable over time, while showing moderate growth most years. Price/earnings ratios, on the other hand, move around quite a bit, with the Standard & Poor’s 500 stocks averaging a valuation in the mid-teens, but with many periods well above or below this level. These valuation metrics have much to do with how well stocks fare in a given period, yet are not given a great deal of attention by most analysts. This is not surprising since it is much easier to forecast future earnings accurately than future price/earnings ratios. What factors influence these valuations? Certainly company-specific measures such as earnings and dividend growth, financial strength and perceived strength of management are part of the equation. Returns from competing types of investment, such as bonds, have an influence, as do external factors such as general economic conditions and rates of inflation. In recent years, there have been interesting studies in the field of behavioral finance of other, less rational factors affecting stock valuation. Effective stock selection should take into account all of these influences.
Where do we stand currently with overall stock valuations? At year-end 2015, the Standard & Poor’s 500 Index closed at 2,043.94. Earnings in 2015 for companies in the Index, when reported, should total about $118.00, for a price/earnings ratio of 17.3, slightly above historic average levels. A reasonable estimate for 2016 earnings is $126, up 6.8%. At the year-end 2015 Index close, these earnings would provide a price/earnings ratio of 16.2, certainly a reasonable level with the economy and corporate earnings showing good strength in most sectors. As a result, we do not share the gloomy market outlook of some forecasters, although neither do we think a major move to the upside is likely. Good stock selection should be even more important than usual in such an environment, and a task which we consider of primary importance. In addition, we will seek to add value through asset allocation decisions, and when appropriate, use of other strategies, such as option hedging, to improve risk characteristics and return potential.
Our very best wishes for the New Year – financially and otherwise!