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Article Submission - by Michael Dever, author of Jackass Investing: Dont do it. Profit from it.
A portfolio diversified across a number of stocks will provide inherent return over time.
It is virtuous and pragmatic to buy-and-hold stocks for the long-run.
If you buy stocks for the long run, they will provide you with an intrinsic return.
The longer your investment horizon, the lower your investment risk.
Short-term stock market returns generally tend to be random.
This conventional wisdom is flawed because it is dependent on a single set of return drivers. There is
no guarantee that the future wont deviate substantially from the past. In fact, its a certainty that it
will. In 1900 there were 36 countries with active stock markets. Half of them ceased to exist or suffered
losses that essentially destroyed all shareholder value. The fact is that when stocks are bought for the
long run, capital destruction is virtually guaranteed. So, is there an alternative approach to
diversification which does not rely on these flawed assumptions of conventional investment wisdom?
The answer is proper portfolio diversification based on the distribution of risk across numerous return
drivers. A return driver is the primary underlying condition that drives the price of a market. There is
no magic intrinsic return provided by stocks. In fact, in the study we present here, we can identify the
two primary return drivers of stock performance.
The essential assumptions of this alternative, return driver-based approach to diversification are as
follows:
Every successful trading strategy or investment opportunity must be based on one or more
fundamental return drivers that are the source of the performance.
By distributing risk across numerous return drivers, no single event or condition can destroy the
value of your portfolio.
Every return driver has a relevant time period over which it is effective.
1
So, if stocks do not provide an intrinsic return (which academics refer to as the risk premium), then
what actually drives stock market performance? In other words, what are the relevant return drivers
of the stock market?
The apparent intrinsic return from investing in U.S. stocks over the past 100+ years was really just the
result of two primary return drivers:
The aggregate profit (or earnings) growth of the companies that comprise the market.
The multiple that people were willing to pay for those earnings (i.e. the price/earnings or
P/E ratio)
The figure below displays the relative contribution to stock prices (represented by the S&P 500
[NYSEArca: SPY] Total Return Index) by each of these two return drivers. Together, they account for
more than 90% of the S&P 500s returns.
Source of Returns
S&P 500 Total Return Index
**A description of the methodology used to produce results in this graph is included below.
The graph shows that in any period of less than ten years, earnings accounted for less than 25% of the
price change in the S&P 500 TR index, while changes in the P/E ratio accounted for more than 75% of
this price change. It is only over the longest periods of time that earnings come to be the dominant
return driver.
2
Most importantly though, this shows that what appears to be an intrinsic return of the market is
simply the aggregate result of corporate earnings coupled with the enthusiasm (sentiment) people have
for buying stocks.
As the graph shows, sentiment dominates short-term stock performance. Over shorter time periods,
stock prices are driven more by the psychology of people buying and selling stocks than by corporate
earnings, as the following example illustrates.
In 1999, Jack Welch was at the top of his game. He had been anointed Manager of the Century by
Fortune magazine, and it was under his leadership that General Electric (NYSEArca: GE) became widely
acknowledged as one of the worlds best-run corporations. World-wide adulation for Mr. Welch and GE
was reflected in the companys stock price.
GE was highly profitable, earning $1.07 per share in 1999 (accounting for a stock split in 2000). At the
end of 1999, GE stock closed at a split-adjusted $38.06 per share and sported a P/E multiple of 35. Eight
years later, during 2007, GE earned $2.20 per share, a 105% increase over the earnings for 1999. Yet the
stock price closed at just $33.06. Despite strong earnings growth over the eight-year period, the stock
price actually fell 13%!
How is this possible? In order to answer this question, we need to examine the proper return driver.
The divergence between GEs stock price and its earnings is explained by the dramatic decline in the P/E
ratio that people were willing to assign to the stock, which fell from more than 35 in 1999 to just 15 by
the end of 2007.
The myth of intrinsic returns is one of the most pervasive of all investment myths, but there is no
magic of intrinsic returns.
Over the short term, stock prices are driven far more by peoples demand (sentiment) as measured by
changes in the P/E ratio than by the companys actual earnings. It is only over the longest periods of
time that corporate performance (earnings) becomes the more important return driver.
Understanding the primary factors (the return drivers) that drive stock prices will allow you to invest
in stocks intelligently and with the conviction that over time the positions will provide returns that
exceed those achieved from random stock selection or from simply buying the market.