Stocks and Shares

The “double compounding” power of stocks

“Stocks for the long run” may be an investment cliché. But, assuming the purpose of investing is to make a profit, it’s also an investment fact. Stocks beat every other asset class over time, and in every country. This is due to what I call stock’s “double compounding” power.

Just recently, Credit Suisse released its annual Global Investment Returns Yearbook. I always make a point of reading it, as it’s stuffed with interesting historical data across many countries.

One of the things it looks at is a comparison of returns from different types of investment in different parts of the world.

The following two charts look at results in the US. They compare long term stock returns with 10 year treasury bonds, short term treasury bills (a proxy for cash deposits), and consumer price inflation.

First up, here are total “nominal” returns, meaning total returns without adjusting for inflation.

A dollar invested in US stocks in 1900 grew to $47,661 by the end of 2017. That means it returned an average 9.6% a year, including reinvested dividends (but before taxes). By comparison, bonds made 4.9% a year and bills 3.7%, with average inflation running at 2.9%.

That’s all well and good. But it’s “real” returns that actually count, meaning after deducting inflation. Real returns are a measure of profits on the money invested, after subtracting the loss of purchasing power of the dollar. (All successful investment involves making a greater total return than what’s taken away by inflation and taxes.)

So here’s the same chart, but adjusted for inflation.

A dollar invested in US stocks in 1900 would buy 1,654 times as much today. That’s a 6.5% real, above-inflation, return (and still before taxes).

By comparison, that same dollar left in bonds would only buy 10.2 times as much today, as it only made 2% a year. Stocks made a real return that was 162 times better than bonds. T-bills made just 0.8% a year and only multiplied the dollar’s buying power by 2.6 times over 118 years!

Before I get into why stocks have left bonds and bills for dust, there’s something else to point out about bonds.

Notice in the last chart how bonds made zero real return between 1900 and the early 1980s (the yellow line). Treasury yields peaked in 1981, and have been falling ever since. All the real gains have come from the massive bond bull market since then.

If, 30 years from now, I’m lucky enough to still be looking at this kind of thing, I’d expect that yellow line to head almost sideways after 2017.

Even long-dated yields are still pathetic (3.1% for the 30 year treasury). The only way that bond investors can hope for any kind of sensible real return is if the US experiences deep and very prolonged deflation. That’s highly unlikely, with the Fed’s fidgety fingers always hovering near the printing presses.

(That said, I still recommend a small 10% allocation to long-dated US treasury bonds at the moment. But only as a hedge against a stock market crash.)

Back to stocks. US stocks have outpaced T-bills by 5.7% a year over the ultra-long run. That’s actually unusually high when compared with other countries. Also, it may not continue in future given that the US economy has now matured, and population growth has slowed. Only time will tell.

Across all the 23 countries studied in the Credit Suisse report, this outperformance averaged 4.3%, in a range of 3% to 6.3%.

However, take note of this: stocks easily beat bills and bonds in ALL those countries. That includes those that found themselves on the wrong end of the 20th century’s major world conflicts, or that suffered hyperinflations.

Why do stocks outperform in this way?

In financial jargon, this outperformance of stocks over bonds is known as the “equity risk premium”. Received financial wisdom, backed up by dry academic analysis, says stock investors make more money because they take on more risk.

But this is misleading.

Sure, if you’re going to need the money in the next couple of years it’s risky to stick it in something that could suffer a sudden price collapse. But if you’re investing for many years or decades, such as to provide for your retirement, it’s a much higher risk to leave your money in low yielding cash deposits or bonds.

The supposed risks of short term stock price swings evaporate with the passage of time. Yet stocks still deliver superior returns to other assets. If it’s not because of risk, why is it?

In my view, it’s down to stocks’ fundamental properties. It’s what I call their double compounding power.

It’s simple enough. Owners of stocks get profit compounding from two sources:

  1. The growth in value of the stocks themselves, as companies reinvest a portion of their cash profits in the expansion of their businesses
  2. An increase in the number of stocks owned as dividend income, paid from surplus company cash, is reinvested. Or, alternatively, a steady increase in the percentage of the company owned, as the company uses its surplus cash for stock buybacks instead, which reduce the share count.

No other type of investment offers this double compounding. Cash deposits, bills, bonds, and even rental properties throw off an income yield. That can be invested in more of the same, for single compounding.

But only stocks have the yield and also the real growth in value of the asset, being real growth in the underlying earnings power of the businesses.

Over time, based on my own analysis and across US stocks as a whole since 1900, these two factors have driven investor profits in roughly equal amounts.

Capital gains from underlying business growth made up about 45% of returns. Investor profits from cash distributions, being dividend income and/or capital gains from stock buybacks, are the other 55%.

(Buybacks only became a major feature after the mid-1980s. Overall they have tended to substitute dividends, at least at the index level. Gross shareholder yields, being dividends and buybacks, are about the same now as they were in the late 1970s.)

Another profit factor comes from changes to valuation multiples. But this effect tends to zero over the ultra long run, since multiples oscillate between extremes but tend to revert to the mean. But changes can make a huge difference to results over shorter periods.

For example, a P/E increase of 50% over three years adds 14.5% a year. A doubling over 10 years adds 7% a year.

None of us invests for 100 years. Hence, for the best results, it makes sense to search out the bargains currently available. Done correctly, this makes a huge difference to results (see here for how I do it).

Unfortunately, this late in the bull market, bargains are relatively thin on the ground these days. That’s why I currently recommend only a 40% allocation to stocks, always bought at a sensible price in relation to the underlying business prospects.

Ordinarily, I’d like that to be much higher, more like 60-70%. If we get a decent crash one day, when the bargain basement will be stacked to the ceiling, that could easily increase to 80-90% for a time, by switching out of cash and into stocks. There’s always loads of money to be made riding a post-crash recovery.

Investing, done properly, is a long term game. Long term investing in stocks, with a large dose of patience and an eye on value, comes with highly attractive odds for the investor.

It’s just a matter of letting stocks’ double compounding power work its magic. Buy well. Apply time.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.