Greg Powell: Hi, I’m Greg Powell, Chief Investment Officer at Miller/Howard Investments.
Gyrations in the short-term can mask the long-term drivers of stock market returns.
This graph shows the calendar year investment returns of the S&P 500 Index going back to 1993. We have decomposed returns into dividends, growth in expected earnings, and the change in the forward price to earnings or P/E multiple. Note that:
- Dividends are always positive and the yield on the broad market is steady.
- Earnings growth forecasts fluctuate, but are positive in almost all years, consistent with a growing economy.
- P/E multiples soar and plunge, causing much of the variation in stock market returns.
The good news is that while changes in P/E multiples have been important in the last couple of years, they have not dominated long-term returns.
This chart shows the annualized decomposition of the S&P 500 returns over 1993-2020. Despite the drama that P/E changes cause year-to-year, the impact on S&P 500 returns during the entire period has been less than both dividend yield and earnings growth.
The broad market has offered good but volatile returns with roughly a fifth of return coming from dividends, a seventh from multiple expansion, and fully two-thirds from earnings growth.
Historic returns are interesting, but what we really care about is future returns. Looking out over the coming decades, we expect dividends and earnings growth to remain important for investment returns, but we expect the average returns from P/E multiple expansion to be zero at best. Why? First, higher P/Es come from ascribing more value to earnings in distant years.
The 40-year downward trend in interest rates has reduced the discount rate investors put on future earnings, pushing the market P/E up. Ever-higher market multiples would require even lower long-term interest rates, an unlikely prospect given their low starting point today.
The second reason investors should not depend on returns from multiple expansion is that we are beginning from a high P/E starting point.
As a point of reference, the forward P/E for the S&P 500 at the end of 2020 was higher than at the end of either 1998 or 1999. Today we have many equally exciting companies as in the Internet Bubble, but investors have always reached a limit on the P/E multiples they are willing to pay. Combining this argument with the nascent trend towards higher long-term interest rates, it seems much more likely that the S&P 500’s P/E will average below recent highs, not above.
But market multiple compression does not necessarily portend poor investment results – it just means that investors need a plan with regards to all three return factors. Here’s our take:
Dividends. Dividends coming from diversified portfolios have proven to be remarkably reliable. Dialing up this return factor increases what should be a low volatility return but must be done with an eye towards not sacrificing earnings growth.
Earnings Growth. As income investors, we are acutely aware that many stocks with high dividend yields have below-par earnings growth. For this reason, we believe investors need to focus portfolios on dividend payers that have the potential to grow earnings at a good pace.
Multiple Expansion. We expect the market P/E to drop on average over time. This should not, however, mean that all equity portfolios will suffer from falling P/Es. We believe that the best defense against multiple contraction is choosing stocks with both good dividend yields and strong earnings growth potential, but that are trading at reasonable valuations.
Thank you for listening today, and for more information, please visit us at www.mhinvest.com.
