Summary:
- Stocks over the long term are wealth generators and compounders
- U.S. stock returns are historically less dividend-driven than European stocks
- Drivers of stock returns are:
- Earnings Growth
- Multiple Expansion
- Dividends and Share Buybacks
- Investing internationally means taking an implicit view on the US dollar
When you buy shares of stock in a company, you become an owner of that company. Ownership entitles you to share in the future earnings power, because earnings go to owners (shareholders). A savvy investor will look at how much they are paying for each dollar of forward or expected earnings of the target company. They would also want to determine if the stock or stock sector is cheap, cheap for a reason, expensive, or astronomically expensive. For this note, we want to focus on the construction of an equity index’s projected earnings growth and its large impact on returns rather than portfolio strategy.
The U.S. stock market is driven predominantly, over the long term, by corporate earnings growth, which is reflected by earnings per share (“EPS”) growth. In Europe, whose economy is not as technology or service driven as the U.S., the market has a larger share of companies whose growth rate is slower than that of their American counterparts but tend to return more capital to their shareholders in the form of dividends. European firms can be industry leaders and industrial powerhouses, but history tells us that dividends contribute more to their stock returns than they do for U.S. stocks. As of December 19th, 2024, the trailing 12-month dividend yield was 3.49% for the Stoxx Europe 600 and 1.28% for the S&P 500.
Share buybacks are another common way for corporate boards to increase shareholder returns by reducing the outstanding share count (supply), which can drive up their earnings per share and stock price. The alternative would be to use that free cash flow on investments or capital expenditures to fuel future profits. Value investors are often satisfied with receiving dividends while growth investors prefer higher future earnings growth and would rather financial managers plow any profits back into the company.
Let’s build what history tells us is the most important piece of stock returns for a U.S. large cap index, EPS growth, using two scenarios:
*Tables are for illustrative purposes only and should not be considered investment advice; numbers in blue are input assumptions.
As we see from Scenario 1 on the left, earnings growth will equal sales growth (all else equal) if the company does not have profit margin expansion. We also get a slight boost in EPS from net buybacks. On the right side in Scenario 2 we have more growth in the form of higher economic growth and the ability of large corporations to pass on higher prices from inflation to consumers. Scenario 2 also incorporates higher profit margins for the index, which adds an extra 4% in earnings growth alone.
Scenario 1 is what one might consider a baseline, and Scenario 2 is a growth scenario in which we may, hypothetically, expect even further increases in revenue growth due to technological advancements like artificial intelligence, or increased earnings growth due to changes in statutory corporate tax laws, etc. The average annual profit margin growth for the S&P 500 Index was 1.9% (see below) and average revenue growth was approximately 4.2% from 2000 to 2023.
Source: Bloomberg Finance LP and BCIS
The main takeaway is that revenue growth drives earnings growth and then ultimately EPS growth at an index level. EPS growth can be broken down into the simple parts of economic growth, corporate profit margins and net share buybacks. We can also see how stocks are (in theory) a long-term inflation hedge, as the inflation rate is additive to revenue growth. As investors, we want to know if large corporations, or asset classes broadly, are growing earnings and by how much because earnings go to shareholders.
Stock Market Returns
In addition to earnings, dividends paid on shares go to shareholders and thus become part of their total return. The dividend yield of 1.28% quoted above for the S&P 500 can be tacked on to the EPS growth number estimated above in either of two scenarios. Dividends are a policy decision by a company’s board of directors and are not guaranteed. We know that approximately 80 percent of S&P 500 companies pay dividends (currently 405 companies) and, even better, some will increase those payout rates annually.
If we have our EPS growth and dividend yield assumptions, we are about halfway there in terms of estimating our total return for a stock index. Looking at the sources of global equity returns graphic below, there is a line in grey identified as “multiples”, which references multiple expansion, or price to earnings (P/E) expansion. The P/E ratio is calculated as a stock’s price divided by its earnings per share (EPS) and can expand and contract over time. Many use the P/E ratio as a valuation gauge to reflect how expensive or cheap an index or group of stocks are relative to historic averages.
The historical average forward P/E ratio of the S&P 500, which uses future expected earnings instead of prior earnings, is around 16 turns or 16x. As of December 19th, 2024, the forward P/E ratio is around 21.5x, which is higher than it was at the beginning of the year. If the P/E ratio increases, it means multiple expansion has occurred and if earnings are growing for the S&P 500 Index, stock prices are growing faster: a good thing for investor returns, but multiples can contract just as fast as they rise.
Source: JP Morgan Asset Management
One could call multiple expansion of the stock market, especially at 21.5x forward levels, animal spirits being unleashed using Keynes’ term, or irrational exuberance using Greenspan’s term, but regardless, it increases stock returns along with the fundamentals of EPS growth and dividends. According to the graphic above, over the past 15 years, multiple expansion added roughly 3% to the average annual total return of the S&P 500. Japan and China serve as a contrast as they have seen multiple contraction in their main stock markets. We would consider a market built on solid earnings growth more durable than one built on significant multiple expansion.
Asset allocators will compare equity valuations using PEG ratios (price to earnings growth) or forward P/E across stock styles, sizes, or sectors to determine attractive areas of the market. Stocks can be expensive for a while because of the stock market paradox: new highs beget new highs. Something externally will ultimately have to kill the inertia of expensive stock market levels like what we saw in 2001, 2008 and 2020; after which the cycle will start over again.
International Shares
To add another layer to all this, let’s think about global currency fluctuations and the light blue line in the above graphic. Chances are you are a U.S. investor like us. When we invest in international stock funds, we implicitly take a view on the U.S. dollar. Take a foreign stock fund’s local price return as an example: add the local currency rate differential versus the U.S. dollar and add dividends paid to come up with your total return.
In periods of serious dollar strength like 2021 through late 2022, international stock returns got impacted negatively due to currency rate differentials. To get around this currency risk you could hedge it in the complex forwards market, buy a Dollar-hedged diversified international stock ETF that does it for you, or invest in U.S. stock funds only.
Summary
Stocks are a classic leading economic indicator and will go through cycles like the economy does, but the stock market is not the economy. Stock prices can get detached from their fundamentals and economic realities, but as we’ve seen, a strong economic backdrop is an ingredient for positive returns. We believe high rates of productivity growth and innovation, especially in the U.S., will continue to generate long-term stock returns for investors.
Index Definitions
The S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry grouping (among other factors) designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
The STOXX® Europe 600 is a broad measure of the European equity market. With a fixed number of 600 components, the index provides extensive and diversified coverage across 17 countries and 11 industries within Europe’s developed economies, representing nearly 90% of the underlying investable market.
The MSCI Europe Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance in Europe.
The MSCI United Kingdom Index is designed to measure the performance of the large and mid-cap segments of the UK market. With 77 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the UK.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The MSCI Japan Index is designed to measure the performance of the large and mid-cap segments of the Japanese market. With 198 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.
The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 598 constituents, the index covers about 85% of this China equity universe.
About Burrows Capital Advisors
Burrows Capital Advisors (“BCA”) is a leading financial advice firm. BCA offers a comprehensive range of investment management services, thoughtfully designed to manage their clients' assets, and the risks embedded in their investment portfolios. Their long-standing commitment to risk management principles underscores their dedication to helping clients achieve their financial objectives with confidence, making them a trusted partner in the investment management industry. Comprehensive services include wealth management solutions, retirement plan solutions, advisory services, practice management support, innovative technology, marketing guidance, regulatory support, and market research.
Burrows Capital Advisors, LLC is headquartered in League City, TX in the Greater Houston metro, located at 2450 South Shore Blvd. Suite 220 League City, TX 77573.
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