Insights

Summary:

What is the true nature of equities? Equities, at their core, are like a perpetual fixed-income security. The coupon of the security being the underlying Returns on Equity (RoE).

Are stocks a good hedge against inflation? A substantial increase in inflation expectations negatively pressures stock prices as the discount rate increases. To counteract that impact of inflation on valuation, Return on Equity needs to increase in the same proportion as the increase in the discount rate.

Over the past 65 years, the RoE of American businesses has been very sticky averaging at about 11.5%.

• • This stickiness of the RoE, across periods of high and low inflation expectations, suggests that investors should not rely on stocks to act as effective inflation hedges.

The underlying RoE serves as an upper limit to the return investors earn over the long-term as:

– RoE is the coupon, and

– Investors incur costs that serve to reduce that return with the primary costs being:

• • Withholding taxes and / or Distribution taxes on dividends – whether incurred in the hands of the company or in the hands of the owner, the ultimate bearer of these taxes is the equity owner;
  • Capital gains taxes which lower that component of the return that is driven by reinvestment of capital, i.e., underlying business value growth;
  • Valuation – depending on the price paid in relation to the economic Book Value of the business, the yield earned from the RoE paid out as dividend is affected; and
  • Frictional costs – The propensity of investors to trade in and out of their holdings creates an additional cost, i.e., trading related costs.

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N.B.: This note was sent to our investors as part of our Q2 2021 letter which was circulated in mid-July 2021.

 

“ .. latching onto things and piercing through them, to see what they really are…” – Marcus Aurelius

One of the primary investor concerns off late has been the possibility of elevated inflation in response to loose monetary and fiscal policies and the impact of inflation on investment portfolios. Many investors are wont to believe that equities provide a good hedge against inflation. However, if you review the investment research articles and notes published during the seventies and early eighties, what you pick up is that during periods of high inflation, equity markets failed to live up to those expectations.

The true nature of equities – the equity coupon

In our effort to understand whether equities can serve as an inflation hedge, the first thing to understand is the true nature of equities. What drives investment return from equities? Pose this question to the so-called investment experts and you will likely hear about ideas like GDP growth, earnings expansion, multiple rerating, etc. Yet, as Buffett wrote way back in 1977[1], equities at their core are like a perpetual fixed-income instrument. The coupon of equities being the Return on Equity (RoE)[2].

As Buffett observed in that article, the RoE of American businesses was rather sticky at around 12%. As we show later in this article, RoE of American business over the past sixty-five years has averaged at 11.5%. This tendency of the RoE of American companies in aggregate to stick around that 12% mark means that it can indeed be thought of as the equity coupon. Importantly, this equity coupon serves as the upper limit of the long-term equity returns. Several factors act to suppress the return that investors in publicly listed equities earn.

For one, equities are seldom acquired at their book value. When investors pay multiples of the book value, the underlying investment return declines. Note that this applies specifically to that part of the equity coupon that is paid back as dividends and buybacks. The active trading around ownership of securities also acts to reduce the returns in the hands of investors by depositing a portion of it in the hands of financial market intermediaries. Lastly, the government also collects its share of that coupon via taxation of dividends and capital gains.

Relationship between return on equity and stock returns – theoretical underpinnings

Note that this section is somewhat technical in nature. So if you are not interested in the mathematics involved, please skip to the section titled “RoE: Driving factor of the investment return equation”.

In a research paper published in 1981[3], Fuller and Petry (F&P) explored the relationship between inflation, return on equity, and stock prices. This section summarizes F&P’s discussion about the relationship between inflation and RoE.

As F&P stated, the value of common stocks can be thought of as the discounted value of all future dividends. Assuming that the net earnings of a business grow at a constant rate forever and that payout ratio remains constant as well, we can calculate the value of the business using the constant growth dividend discount model as below:

where :

V₀ = the estimated value of the business today,

D₁ = the dividends to be received over the next 12 months,

K = the required rate of return , i.e., cost of equity, and

G = the constant growth rate of dividends.

The dividend discount model can be expanded further. Let:

Rₑ = the return on equity,

BV = the book value per share, and

C = the constant payout ratio.

In the formulation above, dividends will equal Rₑ * BV * C. Note that this is an accounting identity. Further, if the return on equity remains constant and there is no additional outside financing, growth in per-share earnings and dividends can be approximated by the proportion of the return on equity that is retained, i.e., Rₑ * (1 – C). The dividend discount model can now be expanded to:

RoE: Driving factor of the investment return equation

The model above makes it clear that for equities to generate higher investment returns over extended periods, RoE will need to shift up. Consider what happens to the cost of equity during periods of persistently high inflation. Persistently high inflation will drive the cost of equity upwards as investors try to maintain the required real return. This, of course, results in valuation multiples contracting as the value of the business will decline as the cost of equity goes up. In this case, for the value of the business to hold at the same level as it was before inflationary expectations took hold, the return on equity will need to increase as well.

Clearly, for equities to serve as an inflation hedge, the return on equity will need to increase in proportion to the increase in the cost of equity. But does RoE respond positively to a signifcant increase in inflation?

US equities – return on equity through time

Figure 1 shows the return on equity for publicly-listed American companies since 1956.More than 40 years after Buffett observed that RoE of American businesses was rather sticky at around 12%, that number has stayed in its place. Indeed, the return on equity of American businesses has averaged at 11.5% over the past 65 years.

A quick note on data: F&P, in their paper, provided data from 1956 to 1979. However, as the data wasn’t available for the S&P’s series, they used the Fortune 500 Industrial series data instead. Later, Frank K. Reilly (Reilly), in a paper published in 1997[4], updated the F&P dataset to the year 1995. In the Reilly paper, data for the Fortune 500 was used for the period 1956-1976, and data for the S&P 400 was used for the period 1977-1995.

We have constructed a custom dataset of the largest 1,000 US companies by market capitalization for our analysis. On the first of April of every year, the list is rebalanced to have the largest market capitalization companies for that year. Our data runs from 1989 – 2020.

Accordingly, the final dataset for this paper uses Fortune 500 data for 1956-1976, S&P 400 data for 1977-1988, and the largest 1,000 companies datset from 1989 onwards.

Figure 1: Return on equity for American companies

Factors affecting returns on equity

Note that this section is technical in nature and discusses the formulaic expression of RoE’s decomposition. If you are not interested in the mathematics involved, please skip to the section titled “What can a company do to increase its RoE”.

While the driving factor behind return from stocks is the return on equity and that return on equity has been rather sticky at around that 12% mark, it is important to note that RoE isn’t an immutable number. Back in the 1920s, the DuPont Corporation created and implemented a formula that breaks RoE into three components, as shown below:

Note that  Net Income / Sales,i.e., the net profit margin can be further expanded to account for the impact of interest expenses and income taxes, elements that are mainly external factors. Accordingly, we can decompose the overall RoE as below:

What can a company do to increase its RoE

The above decomposition provides a complete overview of all factors that are available to a company that can allow it to increase its return on equity. To paraphrase Mr. Buffett, to increase the return on equity, the business will need at least one of the following to happen:

1. improve the operating profitability of the business –there are natural limits to how high can the margins get to and profit margins are already at all-time highs ;
2. lower interest rates – a factor that has already been a big positive contributor and is unlikely to be a positive contributor any further;

• lower tax rates – with the current share of the government in corporate profits at near all-time lows and with the fiscal policies incrementally taking a populist tone, this factor is unlikely to be a positive contributor;

1. higher leverage – much as is the case with the overall economic system, businesses have been highly levered as well; and
2. higher asset turnover – there is some hope of an improvement here.

Corporate profit margins – stable EBIT margin, elevated net margins

Figure 2 shows the evolution of EBIT margin and net profit margin over the past three decades. As is seen, while EBIT margin has been relatively steady around its average of 12%, the net profit margin has improved substantially.

Figure 2: EBIT Margin for American Companies

Interest rate – a persistent positive contributor

Figure 3 shows the interest rate calculated as interest expense divided by average of beginning of year and year-end external debt (long-term debt plus short-term debt) for American businesses. Not surprisingly, the current interest rate is the lowest of the past three decades and is likely to be one of the lowest, if not the lowest, of the recorded history.

Figure 3: Interest rate – Interest expenses as a % of external debt

Tax rate – the lowest tax rate of the past three decades

Figure 4 shows the aggregate corporate tax rate as applicable to pre-tax profits. Much as interest rates, taxes have been a persistently positive contributor to corporate America’s profitability. These two factors, i.e., low interest rates and low tax rates, account for the peak net profit margins of American businesses.

Figure 4: Tax rate – Tax expenses as a % of profits before tax

Leverage – high and stable

Figure 5 shows the total corporate leverage. When measured as total tangible assets divided by equity, leverage levels are relatively steady. However, when measured as external debt divided by equity, corporate leverage is towards historical highs.

Figure 5: Corporate leverage

Asset turnover

Figure 6 shows the evolution of tangible asset turnover for American companies. This tends to be a slow-changing component. In an inflationary environment, it should aid the corporate RoE as sales increase before assets have to be replaced at higher costs.

Figure 6: Tangible assets turnover

Summary

This note aimed to set up the framework for understanding the long-run rate of returns from equities and identify the primary variable affecting the investment returns of stocks over the long-run. As we showed, return on equity serves as the true driver of investment return from equities. Further, as we showed, the return on equity indeed behaves as a coupon, very much as Mr. Buffett surmised in 1977.

For those investors looking at equities as a way to protect against inflation, they will do well to understand the behavior of various components of the aggregate RoE. Two of these components, namely interest rates and tax rates, have driven corporate profitability upwards. In turn, they have also aided the return on equity of American businesses. However, both these factors may very well be near the end of their positive contributions.

Indeed, if inflation was to rise meaningfully, interest rates will follow suit. Similarly, tax rates are much more likely to go up from here than down, driven by populist fiscal policies.

 

Appendix

[1] How Inflation Swindles the Equity Investor, Warren E. Buffett, Fortune, May 1977

[2] For the purposes of this write-up, we define Return on Equity as the Net Earnings of the Business Before Extraordinary Gains & Losses divided by year-end Equity.

[3] Fuller, Russell J. & Petry, Glenn H. (1981). Inflation, return on equity, and stock prices. The Journal of Portfolio Management 1981.7.4:19-25.

[4] Reilly, Frank K. (1997). The Impact of Inflation on ROE, Growth and Stock Prices. Financial Services Review, 6(1):1-17. ISSN: 1057-0810.