What Generates Stock Returns

Benjamin Graham, the intellectual father of stock analysis, is often quoted as saying, “In the short run the stock market is a voting machine; in the long run it is a weighing machine.”

His comment contains two crucial insights. First, in the short run, stock returns are driven mainly by price changes. Over the short to medium term, stock prices can go almost anywhere. However, over the long term, the returns to stocks are driven mostly by earnings.

Let’s digress on this subject for a while, because it all too often gets lost in the noise and hype surrounding stocks, investing, and the stock market.

Recall that returns are calculated by taking the difference between the ending price of a stock and its starting price, plus any dividends that you were paid on the stock.

Pretend for a moment that the stock market as we know it didn’t exist; however, you could invest by buying small pieces of companies, which you would then hold for, say, 30 years. Your ownership would give you the right to receive your proportionate share of the earnings (if any) of the company. Together with your fellow owners, you would decide how much of the earnings to distribute to the owners each year (i.e. dividends), and the remainder would be reinvested by the business, ideally to earn good returns.

The primary way a business grows is by saving part of its earnings and reinvesting those earnings (called “retained earnings” by accountants) into the business. The amounts reinvested by the business increase the book value of the business. (Book value refers to what accountants call stockholder’s equity, of which retained earnings is a part.)

You can see that over a long period of time, your return would consist of the dividends you receive (i.e. earnings that are paid out) plus the growth in the value of the business. That growth results primarily from reinvesting earnings. Therefore, the main source of your return over the long run is the earnings of the company.

That should be obvious, but it is sometimes obscured when media figures, talking heads, and various pundits discuss the stock market.

This insight is valuable enough that I will repeat it: Over the long run, the primary source of returns to owners of companies (i.e. stockholders) is the earnings such companies earn. If you remember this and always keep it in mind when investing, you will, we hope, avoid some of the greater follies that stock investors sometimes fall into.

Medium- and Short-Run Returns 

Stock investing is made much more difficult by the large swings that can affect stock prices in the short to medium run. Often these swings have little to do with earnings or earnings power, but often it is unclear what is causing them.

Over the short to medium term, most of the return (gains or losses) from owning stocks is generated by changes in prices (so-called capital gains or capital losses). These shorter-term swings are what Graham is referring to when he says in the short run the stock market is a voting machine. In the short run, the price of a stock can go almost literally anywhere.

For example, in 2018, the Canadian cannabis company Tilray, which had never earned a dollar and had barely any sales, saw its stock start trading in the public markets in the summer at $17 a share, which valued the company at $1.3 billion. That valuation was 8.5 times the book value, and the company had negative earnings (i.e. was losing money), negative cash flow (i.e. was using up cash, rather than generating cash), and small revenues. Nevertheless, within three months, the stock had (albeit briefly) shot up to $300 a share, theoretically valuing the company at over $22 billion, and 150 times book value! By the next day, the stock had dropped to $150 a share, cutting the market value of the company by $11 billion in mere hours.

Individual Stocks Versus “The Market” 

The stock market is, by definition, the sum of the stocks that trade. One might expect that because every company is different, what happens to the price of one company over a day, a month, or a year would be completely independent of what happens to the price of another, unrelated company. But that is not the case. For whatever reasons, the short- and medium-term price movements of stocks tend to be correlated with each other.

Thus, it makes sense to speak of “the market” going up or down.

Markets and Indices 

While people often talk about “the stock market,” we can be slightly more specific. For example, when we talk about the US stock market, we might be talking about the Dow Jones Industrial Average (DJIA), or the S&P 500 index. Each is an index designed to represent “the market” in the United States. Both do a pretty decent job, because both contain a significant fraction of the total value of the companies traded on the US exchanges, and because, as previously mentioned, stock price changes tend to be highly correlated.

The valuation concepts that apply to individual companies apply to stock markets as well. Over the long run, the return that a stock market generates is mostly determined by the earnings of the companies that compose the market.

Over the short to medium term, the returns to a stock market are determined largely by price movements in the market.

Noise – Information Versus Signal 

In the pre-digital days of radio, it was common to fiddle with a radio dial trying to find a faint broadcast signal among the noise that fills the airwaves. Scientist Claude Shannon at ATT’s Bell Labs developed a theory of information, and part of his theory involved this question of signal versus noise.

Shannon observed that the signal/noise problem exists in many situations outside of radio. In fact, the signal/noise problem exists anywhere that information coexists with a lot of random or seemingly random data.

Stock price information would seem to be an example of noisy data. If you watch the changes in the DJIA from minute to minute, most of it seems random. Randomness cannot be proved, only disproved. But we, and most observers, believe that most of the short-term movements in stock prices are random.

For most people, the fact that short-term stock price movements are mostly random means one thing: You can completely ignore the daily (or more frequent) reports of price movements and miss nothing that matters. The “tale of the tape” is mostly “sound and fury, signifying nothing.”

Valuation Changes 

But you can’t ignore valuation. If the market is trading at a P/E of 30, everything else equal, long-run returns are going to be lower than if the market is trading at a P/E of 10.

Two factors work against you when you invest in an “expensive” market. These factors are the low earnings yield, and the possibility that the market will “reprice” to a lower multiple.

Stocks, like other goods, come with prices, and those prices can be cheap or expensive. There are a number of different ways of determining whether a market is “cheap” or “expensive.” CAPE, or cyclically adjusted price earnings ratio, is one of them. The CAPE uses the current value of the market as its numerator, and the inflation-adjusted 10-year average of earnings for its denominator. In a wide variety of markets around the world, the CAPE, along with similar valuation measures, has done a decent job of forecasting long-run returns from the stock markets.

Although there is quite a bit of noise, a high CAPE probably means a low return over the next decade or two. There are two factors associated with a high CAPE that tend to push future returns toward the lower side of the range. The first is the fact that a high CAPE means a low earnings yield. If there is no change in the valuation level, and no change in earnings, the return will approximate the earnings. The second factor is that a high CAPE has more room to revert to a lower CAPE than it does to move even higher.

Similarly, a very low CAPE means an increased probability of a high return over the coming decade or two. Again the two factors are at play. A low CAPE means a high current earnings yield. It’s easier to earn high returns when you’re getting 10% to start than when you’re getting 3%. Second, if historical ranges provide a reasonable guide for the future, a low CAPE is more likely to rise as it reverts to the mean, than it is to fall or stay low.

The above is an excerpt from “The Investor’s Dilemma Decoded: Recognize Misinformation, Filter the Noise, and Reach Your Goals” by Dr. Roger D. Silk and Katherine A. Silk.

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