February 12, 2015

It seems like many people think of stocks simply in terms of their prices, as if stocks are just numbers on a screen that go up or down. Perhaps that's a useful simplification for day traders, but for long-term investors the reality is different: a stock represents fractional ownership of a real-world business, including a share of all earnings generated by that business in the future.

Those long-term earnings are the biggest component of the stock market's value, so it's obviously critical to have a good estimate of what they might be. Fortunately, this is pretty straightforward at the economy-wide level, because earnings tend to grow at a remarkably consistent pace over the long run. And yet, stock prices vary much more wildly than those long-term fundamental prospects would suggest they should.

Below, we will discuss why this is, the implications of these facts, the tremendous advantage they can confer to patient and level-headed investors, and why it's very unlikely that "this time is different."
 
The Rising Tide of Earnings Growth
It's really hard to reliably predict the long-term earnings of an individual company. The dynamic nature of our economic system and constant technological improvements ensure that things will change in unforeseeable ways. Many companies and even industries that are dominant today may fade to obscurity in decades to come, whereas the dominators of the future may be companies that don't even exist yet.

But it's a different story at a market or economy-wide level. Companies are constantly adapting to changes in technology, the economy, policy, and consumer demand. If there are fat profits to be made, more companies should come in to compete for those profits. If profits get too thin, companies should drop out, leaving more profit to those that remain. Advantages get competed away so that improvements in productivity end up benefiting the end consumers. And all along, the economy grows as people work, invent, and improve.

The result is that over time, the overall economy, and company earnings, tend to grow around a pretty consistent long-term trend. Earnings can vary wildly in the short term, buffeted by crises, booms, busts, and technological breakthroughs. But in the end, companies adapt, digest those changes, and keep competing, and the system grows at that natural long-term rate.

This chart of S&P500 earnings shows huge short-run volatility, but it also shows that through the many important events and technology breakthroughs in the postwar era, earnings have always tended back towards a very consistent long-term trend:
 
S&P500 long
        term earnings

This isn't just a US phenomenon. The below chart of global GDP (not the same as earnings, but highly correlated over time) shows that for all the momentous events and changes in the world over the past five-plus decades, the global economy as a whole has moved onward and upward at a pretty consistent pace:
 
Global GDP

Summarizing so far, and drawing a conclusion:
   
What You Pay Matters
The "catch" on that last point is that getting a share of that earnings growth is great, but only if you pay a reasonable price for it! How much one pays for an investment is a very big determinant of likely returns.

This leads us to "valuation," a hopefully familiar word which refers to measuring the expensiveness of an investment. There are multiple ways to do this for a stock market, but one of the most effective — and the one most appropriate in light of the above discussion — is to measure the price of the market compared to the long-term earnings trend.1

Here are a couple such charts, first for the US, and second for the global stock market. Each of these measures the valuation or "expensiveness" of the market by comparing the market's price to its underlying earnings trend.
 
US stock
        valuations
 
Global stock
        valuations

These charts make a couple of things apparent:
 
As with earnings growth, it makes sense that valuations should "mean revert" this way. If an investment becomes too expensive to support adequate future returns, investor demand decreases, which reduces valuations. As an investment gets cheaper, its yield and prospective returns increase, which eventually draws investment demand.
 
"This Time is Different"
Despite this, valuations fluctuate wildly, often reaching extremes before turning around and heading back towards normalcy. Why?

There is an entire field of study, called "behavioral economics," dedicated to questions like this. For the purposes of this letter we will just offer this very brief summary: human emotion plays a huge role in investing. Cycles of fear and greed dominate the short term, causing the market prices to vary wildly compared to those relatively steady long-term fundamentals, and sometimes pushing them to irrational extremes.

These cycles are self-reinforcing, often fueled by popular "narratives" rationalizing why prices will continue on their current paths. The explanations sometimes focus on shorter-term earnings fluctuations, despite repeated evidence that such ups and downs are just part of how the economy works, and don't really affect the market's long term prospects. But sometimes, investors cite a novel factor at work that will supposedly alter the long-term course of earnings, valuations, or both.

This logic is seductive, because at any given time, investors can indeed point to some feature or circumstance that is completely unprecedented. But that's the flaw in this argument: there is always something completely unprecedented happening — and there always has been. Investors focus entirely on the latest "new" thing, without acknowledging that time and time again, the economy has adapted to momentous changes, companies have competed, earnings growth has followed a steady long-term path, and market valuations have returned to levels that make sense for long-term investors.

It seems pretty bold to bet that these things won't happen again, despite the fact that they have continually happened over and over throughout history, and with good reason. Yet investors continually make that bet, and are seldom proven right.

As investment legend Sir John Templeton put it:


Conclusion (for now): A Powerful Advantage
For those who accept these ideas — that stocks are not just numbers on a screen, but a long-term stream of future earnings; that those earnings have grown at a remarkably steady rate; that valuations tend strongly to mean-revert; and that none of this is likely to have changed — this seems like a good general approach to follow:
 
This approach is, to quote Warren Buffet, "simple, but not easy." We certainly agree that it's not easy — but we think it's worth it for the powerful long-term advantage it can confer on investors with the patience and discipline to follow it.

Our next article will discuss how these ideas apply to the current state of global stock markets.


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1 It's important to measure the price against the underlying trend in earnings, rather than the just using the prior year's earnings as is the more common approach, because earnings can be very volatile over the short term. This can be seen in the first chart above: one-year earnings (the wiggly blue line) can vary widely from the long-term growth trend (the straight black line). At those times when one-year earnings are far from trend, they are giving an inaccurate indication of the likely path of future earnings, which makes them a bad denominator. It is preferable — and has historically been a better predictor of future returns — to approximate long-term earnings potential by using an average of many years worth of earnings (10 years is typical) or using a long-term trendline like the straight black line in that first graph.