Thursday, July 29, 2010

Equities to Double in Five Years?

Mason Hawkins of Longleaf Partners expects equities to do very well versus fixed income in the coming years. Below, he states that stocks will generate annual returns in the mid-teens over the next five years. If he's right, at that rate of return stocks would double in that time frame.

From the Longleaf Partners 2Q Letter:

Equities offer a superior opportunity for investors today, particularly compared to fixed income. The earnings yield of the S&P 500 based on 2011 projected EPS is 9.4%. If adjusted for the approximately $100 of cash imbedded in the S&P, the operating earnings yield increases to 10.4%. The numbers are slightly more attractive overseas. Based on 2011 estimates, the EAFE Index earnings yield is 9.8%. If earnings grow organically from today’s depressed levels at only 5% per year (a rate that does not require the reinvestment of earnings because of current excess capacity), and even if the P/E ratio remains below the long-term average, an investor’s five year average annual return will be in the mid-teens.

By contrast, corporate bonds with fixed, taxable coupons yield much less than the growing, after-tax coupon that companies produce.

The letter includes a table comparing corporate earnings yields to corporate bond yields* at bear market lows since 1932.

When stocks have been at their lowest levels, earnings yields have been an average of 2.8% higher than Aa2 bond yields. At the beginning of July earnings yields are 4.3% above debt yields or almost twice stocks’ relative attractiveness to bonds at bear market lows. We have rarely witnessed this much disparity in the benefits of being an owner of a growing coupon versus being a lender to a fixed one.

Almost a decade ago, the earnings yield or inverse price/earnings on many quality stocks** was around 3% while corporate bonds were yielding over 7%. Today, it's not difficult to find stocks with 9% plus earnings yields compared to corporate bonds that are currently yielding less than 6%.

A complete reversal.

Adam

* Long-term corporates.
** Back then, the DJIA components collectively were more reasonably priced than the S&P 500 with an earnings yield of 5.6%. Many stocks had earnings yields of 3% or even much lower in the early 2000s. For example, the S&P 500 earnings yield was ~3% but the NASDAQ's earnings yield was...well...clearly much lower than that during the tech bubble.

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