Monday, August 13, 2012

GMO's Ben Inker: Death of Equities Greatly Exaggerated

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in the 1992 Berkshire Hathaway (BRKa) Shareholder Letter

This should be my last post on growth and returns (a subject I've covered quite a bit in recent years) for a while, but Ben Inker's new white paper provides insights on the subject worth highlighting.

Inker does a good job of explaining the relationship between GDP growth and returns (or lack thereof).

Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns

Two of my recent posts dealt with the relationship between growth and stock returns. The bottom line being that there really isn't one despite what seems to be an obsession with chasing growth often at a high price relative to near-term profitability.

It is the earlier part of Inker's new paper that covers the growth versus stock returns subject very well providing lots of useful charts and data.

From the paper:

"The first point to understand about stock returns is their relationship with GDP growth. In short, there isn't one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns. This has been true empirically, as the Dimson-Marsh-Staunton data from 1900-2000 shows. Many investors are utterly convinced that strong GDP growth is the primary reason why one country's stock market will outperform another."

Later in the paper Ben Inker added...

"Insofar as there is any relationship here, it's a perverse one. All else equal, higher GDP growth seems to be associated with lower stock markets returns. How could this possibly be? Don't earnings grow with GDP and stock prices with earnings?"

Well, as it turns out, the answer is no.

Yes, aggregate profits should grow with GDP.

As should overall market cap grow along with those aggregate profits.

The problem is this doesn't reveal much about value on a per share basis. Companies may issue stock to fund growth. They may pay too much for growth or invest in growth that produces a low return on capital for shareholders even if it makes the company, in total, much bigger.

Also, high growth environments attract competition and shareholders, excited by the prospects for growth, tend to pay a premium for high growth prospects.

All this serves to cloud what otherwise would seem to be a much clearer picture.

Sometimes it's the counterintuitive stuff that's most profitable. I think it's worth taking some time to more completely understand the not always so obvious relationship between growth and returns.

Ben Inker's paper deals specifically with the relationship between GDP growth and stock returns yet at least some of the insights apply more broadly.
(ie. A high growth industry is not necessarily a high return industry for shareholders nor do necessarily high growth individual companies.)

"...business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain." - Warren Buffett in the 1992 Berkshire Hathaway Shareholder Letter

In specific situations, growth can certainly be a good thing but it is just far less assured than some seem to think. Frequent readers of the blog with find none of this to be unfamiliar territory.

More from the paper:

"Total corporate profits and total stock market capitalization have very little to do with earnings per share or the compound return to shareholders because new companies, stock issuance by current companies, stock buybacks, and merger and acquisition activity can all place a wedge between the aggregate numbers and per share numbers."

Ben Inker's paper covers more than just the lack of correlation between GDP growth and stock returns. In fact, it makes four other major points in some useful detail.

Check it out in its entirety.

Certainly well worth reading.

Adam

Related posts:
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009
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