InvestorsFriend Inc. Newsletter January 8, 2011

How Much \$ Can You Expect to Make from Stock Investments??

Let’s think about how much money we should expect to make from our stock portfolio? Should we expect 5%, 8%, 15% per year on average? How about minus 10%?

As I start to write this article I don’t know the answer I will arrive at – but I have a pretty good idea and and I know how to calculate it. In the rest of the article I will walk through how to calculate an expected average annual return.

First, let me be clear that the answer will only be an “expected” number, it will in no way be a precise number that we can count on. But as Warren Buffett has said, it is far better to be approximately right than it is to be precisely wrong.

And let’s be clear that while we can calculate an expected average annual return, the variability around that average (even if we get the average correct) will be huge in any given year. Even if the average is 8% per year, you can count on the fact that the returns from stocks in some years will be negative.

As I have explained previously we can divide the returns from stocks into precisely two sources: 1. returns made from other investors through astute trading and 2. returns made by the companies in providing products and services to their customers.

Trading is by definition a zero sum game (well, actually it is negative after deducting the fees and other costs of trading). So by definition, on average, zero (or a little less) is made from trading by the average investor.

So, let’s accept that the average return we can expect to make from stocks is solely related to the money that the companies we own will make from serving their customers. (After calculating that, if you think you are a smarter-than average trader you can add something on for that, but for the average investor, let’s accept that trading adds zero).

I will use my own portfolio to work through the math of calculating an expected average annual return from stocks.

My portfolio of stocks is really part ownership of a group of companies. My portfolio, as of the start of 2011, has the following characteristics

• Average Dividend Yield 2.14%
• Average Price to Earnings Ratio 15.99 (normally I would call that 16.0, but I am working with two decimals here to insure the math works out despite rounding)
• Average Return on Equity 14.19%
• Average Price to Book Value 2.27

The price to earnings ratio of 15.99 means that the stocks are trading at 16 times their current earnings level. Expressed another way the earnings over price is 1 / 15.99 or 6.25%.

So the stocks (the companies – always remember it is companies you own, the stocks are just certificates of ownership in companies) I hold earn just \$6.25 per year for every \$100 of my portfolio.

I will pause here to note that this is a little scary. If my stocks (my companies) are earnings only 6.25% on my money, how will I expect to earn more than that? Well the good news is that I can indeed expect to earn more than that as I will explain below.

But first let’s look at the dividend. It’s a 2.14% yield so \$2.14 per \$100. Some people claim that dividends are the only return that matters. If so, I have to expect a lot of growth in this dividend in order to bring the total return up to a reasonable level.

Now, the stocks (the companies) I own have an average  price to book value ratio of 2.27, meaning that the companies only have book equity of \$100/2.27 or \$44.05 for each \$100 in stock value that I own.

The companies on average make 14.19% on that \$44.05 which, not coincidently, works out to my \$6.25.

So, I own a group of companies which for every \$100 in value on the stock market have accounting book equity of \$44.05, on which they earn 14.19% or \$6.25, resulting in an earnings yield for me of 6.25%.

If the companies were to dividend out the entire \$6.25 in earnings and if therefore their earnings would not grow then I could expect to earn precisely 6.25% on this portfolio.

Fortunately, the companies retain some of the earnings for growth. In this case the companies retain \$6.25 minus \$2.14 or \$4.11 or 66% of the earnings.

Let’s assume that the companies continue to make the same 14.19% return on their existing equity and on the additional equity provided by the retained earnings.

In this case, we will make our 6.25% on the 34% of earnings that is paid out in dividends and 14.19% on the 66% of earnings that are retained. In that case our average return is 6.25% times 0.34 plus 14.19% times 0.66 or 11.5%.

So my expected average return on this portfolio assuming the companies continue to make 14.19% ROEs and continue to retain 66% of earnings is 11.5%. An attractive return and far better than the 6.25% that the 16.0 P/E (1/16 E/P) at first suggested.

We can also calculate this on the basis of dividends rather than earnings.

The dividend yield is 2.14%. If 66% of the earnings are retained and a 14.19% ROE is earned then we should expect the dividend to grow by 14.19% times 0.66 or 9.36% per year. Our expected return can then be calculated as the 2.14% plus the 9.36% growth or, not coincidently, 11.5%.

So, I have calculated that my portfolio can be expected to earn me 11.5% per year.

But that assumes my companies can continue to earn their historic 14.19% ROE on historic equity plus on retained earnings.

If instead, I assume the ROE on historic equity will be 14.19% but that ROE on retained earnings will be lower at 10%, then my expected return drops to 6.25% times 0.33 plus 10% times 0.67 or 8.76%.

To calculate the expected return on your own portfolio you can use either of the following two formulas:

Average annual expected return equals:

1. E/P (i.e. 1/P/E) times earnings payout ratio plus future ROE times (1 minus earnings payout ratio), or

2. Dividend yield plus expected average annual growth in dividends

Dividend yield plus expected ROE times (1 minus earnings payout ratio)

Now these formulas do assume that the ROE is not going to change and also assume the P/E ratio is not going to change.

In my case with a portfolio ROE of 14.2% it may be a little aggressive to assume that this will not decline. Perhaps the scenario where I assumed a 10% incremental ROE on the retained earnings is more reasonable.

In my case with a portfolio P/E of 16, my assumption that the P/E ratio is not going to change is not unreasonable. If my portfolio P/E was 25, it would however be unreasonable to assume that it would not decline in future.

Note that while  these formulas may work approximately on a portfolio they are very unlikely to work for an individual stock since the assumptions are much less likely to hold for one stock but may approximately hold for portfolios.

Unfortunately, these formulas may not be that easy for you to apply since it will take some work to figure out the average dividend payout ratio of your portfolio, or even the weighted average P/E and dividend yield. However for those who are mathematically inclined and who are prepared to do some work, these formulas may be quite useful.

MENTAL MODELS

Charlie Munger, Warren Buffett’s partner advocates the use of mental models to make sense of a complex world.

Scientists use simplified models all the time. The motion of an object falling through the air is modeled first as the motion of an object falling through a vacuum. The vacuum model does not give the same precise answer as the more complex situation of an object falling through the atmosphere. But often is is close enough.

The book Blink: the Power of Thinking Without Thinking, discusses how we can use certain quick mental models to recognize instantly when something is obviously false. And that there are huge benefits to the ability to make snap decisions based on certain mental models. And let’s face it we need to make snap decisions all the time. Do we engage that stranger in conversation or not? Do we cross the street when we see the lone stranger ahead walking toward us at night?

Mental Models and the Economy

The economy is very complex, and we are often confronted with various claims about the economy and it would be useful to have mental models that allow us to make a quick decision on whether a certain claim is true or even has any chance of being true.

Here are some common examples of big economic claims:

• Citizens can protect jobs and become better off by buying locally
• There are only so many jobs to go around
• Americans can become wealthier if the price of houses rise
• Every country should strive to Export more than it Imports
• An earlier retirement age is a good idea to create jobs
• There is money on the sidelines that may soon make stock markets rise
• The world has too much debt
• Every household should spend less than it makes
• A stocks is worth what someone will pay for it. End of story
• You won’t make any money in stocks

And here are some of the mental models that I use to decide that all of these claims are false.

1. I think about whether the economic claim could be true if applied to the world as a whole.
2. I think about whether the economic claim could be true if the entire world economy consisted of a village or town of a few thousand people.
3. I think of the real wealth of the world as being its natural resources, plus all of the accumulated knowledge of man, plus all the built infrastructure including roads, buildings, bridges, factories, production processes etc., all the stock of manufactured goods that exist, all of our ability to provide entertainment, services, and desired comforts of all kinds to each other. Money is not wealth itself but rather represents a claim on the real wealth.
4. I think of stocks as part-ownership claims on companies.
5. I think of the stock market as a place where people exchange stocks with each other (and usually not with the actual companies they buy or sell) for money.
6. The wants, needs and desires for pleasure and comforts of (the vast majority of) individuals and of populations is basically infinite.

So let’s apply my mental models to some of the claims above.

Citizens can protect jobs and become better off by buying locally?

If you are a business owner and want to buy local in the hopes that others will do the same that may be entirely rational. And I am not suggesting that it is bad for individuals to favor local (especially when all else is equal) if they wish to. What I do conclude, based on my mental models of the world, is that a general behavior of encouraging buying local is a step back towards the stone age.

There are only so many jobs to go around?

Hmm so let’s see, if a “job” represents being paid to perform work of some kind that someone values enough to pay for it, then it is hard to imagine any intrinsic shortage of jobs. If the world consisted of 10,000 people living off the land, would there ever be a shortage of things that needed doing? Is there a shortage of things that need doing around your house? Are your desires completely fulfilled so that there is not a single thing that you would at this moment pay someone else to do? So no, I don’t accept that the number of jobs is limited.

The World has too much debt?

Well, consider that one man’s debt is the receivable or the investment (the savings) of another man. So the net amount of debt, being debt minus savings, it seems to me must always net out to zero. It seems to me that too much debt implies too much savings, and I can’t quite accept that there is too much savings. The world as a whole has not borrowed from future generations since they are not around to lend us any money. The world as a whole has not borrowed anything from outer-space. So maybe you have too much debt, or your neighbor does, or the U.S. government does. But based on thinking about the world as a whole it seems rather impossible for the world as a whole to have too much debt.

You won’t make any money in stocks?

Wells since to own a stock is to own a piece of a company, this claim is requires that companies will not make any money. Since I believe companies will continue to make money, I have to believe that the owners of companies will continue to make money in the long term.

Our Performance

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END

Shawn Allen, President
InvestorsFriend Inc.

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