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Rupert Hargreaves
Rupert Hargreaves
Articles (630)  | Author's Website |

Howard Marks and James Montier: Expect Lower Equity Returns

After record-breaking returns since the crisis, Marks and Montier believe investors should accept lower returns going forward

September 13, 2017

Howard Marks (TradesPortfoliorecently published a memo titled "There They Go Again... Again," which has reportedly attracted the most interest “in the 28 years I’ve been writing memos, with comments coming from Oaktree clients, other readers, the print media and TV.”

It is easy to understand why the memo has sparked such interest. In it, Marks warns the current market environment has many similarities today to that of the dot-com bubble and pre-financial crisis bubble. He also weighed in on the opportunity presented by bitcoin and other trends currently overtaking the market. The response to the original memo has been so great, Marks decided to write a response outlining the lessons he has learned from speaking with readers and listening to criticism. As always, the memo is highly recommended reading.

Investing in a low-return world

Marks summarizes the memo with some guidance on how to invest in a low-return world -- the original focus of the first memo. To make the most of the current environment, he says Oaktree is combining three options (out of the six avenues currently available to investors):

  1. Invest as you did in the past, but accept that returns will be lower.

  2. Reduce risk to prepare for a correction and accept still-lower returns.

  3. Put more into special niches and special investment managers.

Marks is not alone in his view that investors should expect lower returns going forward.

The latest research paper from GMO’s James Montier and co-author Matt Kadnar makes a similar point.

Negative returns as multiple expansion slows

Montier’s paper considers the key historical drivers of equity returns since 1970. Specifically, between 1970 and June 30, an investment in the S&P 500 has produced a real total annual return of 6.3%, of which 3.4% has come from dividends while 2.3% has come from growth. Margin expansion has accounted for 0.5% of returns, and multiple expansion has accounted for 0.1%. So over the 47 years, the bulk of equity and investors’ returns have come from dividends and growth. Dividends have been the largest component of returns.

This pattern, however, has completely changed over the past seven years. Between 2015 and June 30, the S&P 500 has produced a total real return of 13.6% per annum, but instead of dividends, the largest returns contributor over this period has been multiple expansion, accounting for 3.8% of the growth. Margin growth is the second-largest contributor, accounting for 3.2% of the S&P 500's total return. Returns from dividends and earnings growth have fallen to third and fourth place. During the period, dividends only accounted for 2.8% of the S&P 500's total return.

This trend cannot continue. Profit margins cannot go up forever, and neither can multiples. That being said, trying to predict when these factors will stop expanding is impossible. All we know is the return from the dividend factor is likely to remain constant. Montier and Kadnar estimate that, assuming the markets price-earnings (P/E) multiple returns to its equilibrium of 16, down from the current 24.4, and profit margins revert to the equilibrium of 5.7%, compared to 6.9% currently, investors should expect an annualized return of -3.9% for the next seven years. It is highly unlikely this exact return will materialize, but the figures do make it clear investors should expect a lower return going forward.

On the other hand, if robots continue to replace jobs, tax cuts take force and companies reinvest all profits into buybacks rather than capital expenditures, there is no reason why profit margins and multiples cannot continue to expand for the next seven years.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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