Investment Strategy

Pyramids, profits and how to get the most from stocks

It’s well-established that stocks beat bonds and cash in the long run. The historical record is indisputable. But the standard financial theory about why this happens is flawed. Today’s article looks at the actual fundamental features of stocks that I believe explain their outperformance. It also highlights the key personal virtue that guarantees profitable outcomes for stock investors.

Every year since 1956, British bank Barclays has published a report called the “Equity Gilt Study”. It’s an authoritative source for historical investment data in the US and UK.

The 2018 edition has information about total returns on stocks (equities), bonds and cash since 1899 in the UK and 1925 in the US, both up until the end of 2017. In the case of the US, bonds refer to 20 year treasury bonds. In the case of the UK, bonds refer to 20 year gilts until 1990 and 15 year gilts since then.

In both countries, the historical record is clear. Stocks outperformed bonds by a wide margin, which in turn outperformed cash. Below is a chart that summarises average real returns (after deducting consumer price inflation), with all dividend and interest income reinvested (and before taxes).

Two things really stand out:

  1. Stocks clearly beat bonds in both countries (on average, by 4.1% a year in the US and 3.8% a year in the UK).
  2. US stocks beat UK stocks by 1.6% a year.

I’ll come back to point 1, and why it occurs. First, a quick note on comparing performance of US and UK stocks. A big difference is the time period. UK data stretches back to 1899 whereas US data (in the Barclays report) starts in 1925.

It just so happens that the first quarter of the 20th century was a period of poor performance for British stocks. Not least, this was because of the First World War (1914-1918). For example, real prices fell really hard in the three years from 1915 to 1917 inclusive. Incidentally, it was also a high-inflation period when fixed-income bonds were decimated.

Using the underlying data, I’ve calculated that stocks in the UK returned an average of just 2.7% a year during the first quarter of the 20th century. In turn, we can compare the performance of US and UK stocks since 1925, on an “apples to apples” basis. That’s summarised in the next chart:

Clearly, US stocks still outperformed, by an average of 0.9% a year. This should be no surprise, given that the US was an economy with strong underlying fundamentals for much of the time. For example, an important driver of long-term economic growth was its relatively fast-growing population (meaning more people to buy things each year).

In any case, the key point is that stocks beat bonds. The next chart shows how $100 invested in US stocks (equity) in 1925 would have performed over time, relative to bonds and cash and with income reinvested (and no tax costs).

(Note: the scale is logarithmic, which just means the same percentage increase or decrease always looks the same to the naked eye. Also note the figures are ‘nominal’ in this case, which means not adjusted for inflation.)

Remember that US stocks outperformed bonds by 4.1% a year, on average. This is what financial theory refers to as the “equity risk premium” (or ERP).

The idea is that stocks are supposed to be riskier than bonds or cash, so investors are meant to get a higher return for taking that extra risk. In reality, the situation is more subtle than that.

‘Risk’ is defined, in this kind of financial theory, as a function of price volatility. And it’s certainly true that stock prices are more volatile than bond prices, sometimes swinging wildly up or down.

This means that short-term outcomes for stock investors vary hugely, depending on specific stock investments but also macro market conditions. Stocks bought just before a market crash will probably result in a huge loss after one year. Stocks bought shortly after a market crash most usually result in a huge gain in the first year.

But, over longer holding periods, the variability of likely returns narrows substantially. In fact, looking at the historical record, the variability reduces to a point where it’s comparable with – or even smaller than – the variability of returns on “low-risk” bonds. What’s more, the longer the holding period for stocks, the higher the minimum return is likely to be.

In the case of the US stocks since 1925, no consecutive 20-year holding period resulted in a negative real return. In other words, investors that bought US stocks in any year since 1925 beat inflation, at a minimum. In fact, the range of 20-year real outcomes was from a minimum of 0.9% to a maximum of 13%, with the average at 6.7%.

Below is a chart that summarises the range of historical outcomes for US investments over different lengths of holding period.

You can see that the range of historical outcomes for stocks narrows very significantly as the holding period gets longer. Also, that the minimum historical return of US stocks almost matched bonds for 5 year periods, and beat bonds for 10 year periods.

Looked at another way, stock investors get handsomely rewarded for being patient. You could call the above chart the “patience pyramid of profits”. The more patience the stock investor has, the more likely that they’ll be rewarded with a profitable outcome. Stocks investors that wait long enough are basically guaranteed a real return.

This finding places the concept of the “equity risk premium” in doubt, at least as far as it’s usually defined. Remember, it’s meant to reward stock investors for taking on extra risk in relation to bonds. But the evidence suggests stocks are actually lower risk than bonds over longer holding periods, or at least not meaningfully riskier. Yet the average returns are still substantially higher from stocks.

In reality, at least in my view, the extra profit from stocks shouldn’t be seen as a premium for risk. Instead, it should be renamed the “patience premium”.

Stock investors that have deep wells of patience, and that stick to their guns, have a very high probability of getting good results. Meanwhile, impatient short-termists have a much higher chance of losing money. They’ll need greater amounts of skill or luck to come out on top.

The question then becomes this: If extra price volatility doesn’t explain or justify the premium returns of stocks in relation to bonds, is there an alternative financial explanation for this “patience premium”?

I think it’s pretty straightforward. It’s what I call the “double compounding” feature of stocks.

 

The real reason why stocks outperform

The first layer of compounding comes from the reinvestment of cash income into extra investments. That applies equally to both stocks (dividends) and bonds (coupon interest).

The second layer of compounding comes from additional increases, over time, of the underlying value of the investment itself. This is required to achieve double compounding.

That second layer applies to stocks, since the underlying business value increases across the years, as profits and assets grow. Also, dividend income grows over time (assuming a constant payout ratio, as a proportion of profits), providing an increasing amount of cash to reinvest.

Assuming a stock portfolio has a dividend yield of 5%, this means the investor can add 5% to the portfolio each year from dividend reinvestment. At the same time, assuming earnings grow at 4% a year (and no change to valuation ratios), the value of the stocks – bought originally or added later – go up by 4% a year. Hence the total return is 9% a year. (These figures are broadly in line with the actual, historical record.)

Whereas, a fixed-coupon bond doesn’t enjoy these growth features. The issuer borrows $100 and pays back $100 when it matures. Assuming the bond pays $6 in year one, or 6% yield, it will continue to pay $6 in all subsequent years. If the bond always trades at par, and the $6 income is always reinvested, the return will be 6% a year. (Again, this is broadly in line with history.)

Put another way, let’s assume inflation is 3%, bonds yield 6% and stocks have a dividend yield of 5%. For stocks to perform the same as bonds, nominal capital gains would have to come to 1%, being the difference between the income yields. In turn, that implies profit growth that’s 2% below the inflation rate – meaning shrinking by 2% a year in real terms.

If that’s all that businesses could achieve, it would be a pretty poor state of affairs. In fact, underlying profit growth of listed US corporations averaged somewhere around 1% above inflation in the past. I’d expect that to continue in the future.

Stocks of companies that operate in a market economy are hard-wired to outperform government bonds, over the long run. Put another way, equity capital invested in private businesses makes a greater return than money loaned to the government. Who’d have thought it?

Of course, bonds performed extremely well since the early ‘80s, as yields fell and fell, and total returns almost matched those of stocks. But that’s just because yields started in the teens and inflation fell over time. It’s simply not repeatable over the next few decades, given already low yields today, even if bonds go back into a bull market in the shorter term.

In short, to ensure the highest chance of decent profits, investors need two things:

  1. Stocks
  2. Patience

Over time, they’ll be well rewarded with the “patience premium”, itself explained by the double-compounding power of stocks. If they wait long enough, stock investors are guaranteed to make a real profit.

For the very best results, investors also need to buy the right stocks, meaning the ones where high profits are most likely. Like the stock that’s made +17% for investors since I recommended it less than four months ago, and I believe has much more profit to come.

That recommendation was made to members of my OfWealth 3D Stock Investor service. It highlights stocks of solid companies with excellent prospects, meaning the combination of business growth potential, income yield and value.

Of course, not every stock performs immediately. Patience is still key. But all of my recommendations have high profit potential over the course of a few years. That’s because I use a strict screening system before I recommend them. If you are looking for profitable stocks, you can find out more here.

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.