August 2021 – Reasons to be a Long-Term Investor – Part II

In our last Market Commentary, we examined the historical reason for being long-term equity investors. We saved the theoretical reasons for the end of summer for some reason. Alright, I admit there is never a good time to discuss finance theory for those of you not so analytically inclined. In any case, mute your cellular device and fill your coffee cup with the strongest brew you have available. If you’re ready, let’s begin.

Morningstar is a provider of independent investment research to financial advisors, asset managers, and investors. One of the most thoughtful researchers at Morningstar is John Rekenthaler, who recently wrote a piece entitled “The Long-Term Forecast for U.S. Stock Returns: Expect 7.5%.[1]“ In it, he writes “Returns for U.S. stocks have been erratic in the short run, but they are reasonably foreseeable over the long haul.” Citing a formula from Warren Buffett, he arrives at his 7.5% annual average long-term return forecast by estimating three components of stock returns: real (inflation adjusted) corporate earnings growth (2%), plus the current dividend yield (2.5%, if you include stock buybacks), plus expected inflation (3%).

Looking back over the past 71 years, Rekenthaler shows us that Buffett’s earnings and inflation estimates come out pretty close to reality:

Be aware that the 7.5% is just an estimate, and a very long-term estimate at that. It is not a guarantee. It also doesn’t take into account fees, expenses, and taxes. Your actual returns from investing in stocks over the next several decades may be higher or lower than this. Let me know in thirty years.

You’re probably thinking, “Gee-wiz, this is finance theory lite…back-of-the-envelope kind of stuff” and I wouldn’t disagree. Now we get to the final reason to be a long-term investor, so you might want to refill that coffee cup. For this I turn to an academic research paper written by a professor from Wheaton College (IL), and a good friend of mine, Dr. Bruce Howard (now retired).

Bruce, a very gifted accounting and economics professor, set out to show that there should be a close relationship between what the assets of a firm can earn and what investors in that firm can expect to be rewarded with, by putting their capital at risk. In technical terms, Bruce writes that “there should be a corresponding balance between the marginal product of assets (physical capital) on the left side (of the balance sheet) with the price of capital on the right side.[2]

Over breakfast recently, Bruce explained the concept this way: suppose you had a vending machine that produced something worth $20 every time you put money into it. You start by putting $1 in and over time the amount required increases to $5, then $10, then $15, but it always produces the $20 product. When would you quit putting in money? Just shy of $20, right? The inputs correspond to the financing costs, whereas we assume the outputs generated by the assets remain constant. There is an economic incentive to continue funding production as long as the marginal value of your outputs exceeds the marginal cost to fund it.

As a finance geek, I would explain this in a slightly different way:  A company should always continue to invest in assets that produce a marginal return that exceeds that company’s cost of capital (i.e., the return expected by shareholders plus the interest on any debt). As long as a company can find attractive products or markets that can produce a marginal return greater than the company’s overall cost of capital, that company will create wealth for its owners.

I’ll spare you the methodology Bruce used, but his research supported his initial thesis: he concluded that, from 1950 to 2007, “the real annually compounded rate of return on large cap equities (7.75%) is virtually identical to the annually compounded rate of marginal product of capital (7.87%).” Remember that these results, adjusted for inflation, cover a multi-decade period. Shorter time periods introduce greater variability. We can see this when looking at the range of annual total returns for U.S. stocks, bonds, and a 50-50 blended portfolio over one-, five-, ten- and twenty-year rolling periods from 1950-2020:

The key takeaway for long-term investors is that, as long as firms can successfully invest in projects that return a profit in excess of their cost of capital, those firms will continue to grow, creating jobs and increasing the share price for their owners. This is the essence of capitalism, along with free enterprise and the entrepreneurial spirit. As long as the legal, regulatory, and competitive environment for business remains supportive, long-term investors can feel justified in allocating their capital in common stocks.

Well done, readers. You may now unmute your cellular device.

[1] “The Long-Term Forecast for U.S. Stock Returns”, John Rekenthaler, Morningstar Direct, 6/17/21

[2] “The Cobb-Douglas Justification of Long-term Returns on Equity”, Bruce Howard, PhD., Wheaton College, 2013
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