Amid all the talk of a bitcoin bubble, there’s another bubble brewing in the asset management sector.
Passive investing might not seem like a bubble at first, but I’ve heard more than one analyst label it as such. The logic behind this statement is compelling. Analysts speculate that the passive bubble is based on an investor drive for performance. Thanks to several years of high equity returns, investors are now piling into passive products, believing that these will continue to generate high single-digit/low double-digit returns going forward.
The chances of this happening are slim, but not impossible (it’s foolish to try and predict market moves over the long term).
The most convincing argument against a continuation of the current equity bull market is the makeup of returns since the financial crisis. GMO’s James Montier put out an excellent piece on this a few months back.
The makeup of returns
According to Montier’s research, between 1970 and June 30, an investment in the S&P 500 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%.
However, 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.
Can margins and multiples continue to expand forever? It is possible, but it’s unlikely. There is an argument that due to technological advances, higher margins are here to stay. What’s more, the availability of financial information has led some analysts to conclude that markets today do deserve higher multiples because they are more efficient (plus profit margins are wider and many large firms run an asset-light model).
The question investors need to ask themselves is whether or not they are prepared to trust passive trackers or not. Will returns from these instruments over the next decade or so actually be better than active funds? Considering the makeup of gains over the last two years, it’s unlikely.
That said, markets are unpredictable, and it may very well be the case that the S&P 500 continues to march higher.
The solution to the problem
The answer to this problem is compounders. Investing in businesses that have a record of compounding wealth at a steady rate.
This strategy will enable you to profit from the compounder’s return if the market struggles to move higher, while at the same time leave the door open to benefit from the broader market rally.
Coca-Cola (KO, Financial) is the best example of a compounder. This company has more money than it knows what to do with, so management is devoting the majority of its free cash flow to buyback and dividends. As the firm’s product is not cyclical, this should not change anytime soon. The stock’s total shareholder yield (including repurchases) is around 4.5%.
Over the past 10 years the stock has produced a total return of 10.6% per year, underperforming the S&P 500 by 3% per year, but the shares have continued to trade at an earnings multiple in the range of 17 to 19 times during this period, and margins have remained mostly unchanged. Almost all of the returns have come from earnings growth and cash returns.
Coca-Cola is a heads-you-win, tails-you-don’t-lose-much stock. If the S&P 500 starts to struggle, the company will still produce returns for investors and if the S&P 500 continues to move higher, Coke will rise in line. Think of it as a low-risk market hedge. And it’s not the only one of its kind out there; there are plenty of other compounders with similar traits.
Disclosure: The author owns no stock mentioned.
