Introduction

Below, we cover the difference between investment return and market return, including speculative return. We also cover the difference between historical return and expected return.

Investing v Speculation

Investing is about the long-term ownership of business and, thereby, the accumulation of intrinsic value. As Seth Klarman explains,

Investors in a stock thus expect to profit in at least one of three possible ways: from free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends; from an increase in the multiple that investors are willing to pay for the underlying business as reflected in a higher share price; or by a narrowing of the gap between share price and underlying business value.1

In the very long-term, all returns are created by investment. Businesses innovate and make capital expenditures: by developing new products, by reducing costs, or by improving overall efficiency. All of these drive profitability. Society benefits because companies create more products and services that consumers demand. John Maynard Keynes described investing as “forecasting the prospective yield of an asset across its entire life.”2

Speculation is about short-term expectations. It is based on the assumption that an asset’s price–as distinct from its intrinsic value–will rise. Speculators focus on changes in other investors’ psychology and their willingness to pay for a particular asset. Speculators trade on momentum. Effectively, they are gambling. The result of all these speculators’ combined activity is randomness in daily financial market returns (i.e. “noise” in the system)3.

As Seth Klarman observes,

Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals4

Similarly, John Maynard Keynes described speculation as “the activity of forecasting the market”.

Investment Return v Market Return

An individual company’s market return is the sum of its investment return and its speculative return.5 Its investment return6 is a function of:

1. its dividend yield, and
2. its earnings growth.

All calculations of investment return start with the real risk-free return plus a premium to offset expected inflation. Equity investors’ total return then includes an additional return to compensate for market risk. Additionally, equity investors need to receive a return above market to justify investing in a particular stock group or individual stock.

In the short term, asset price changes are unpredictable. Stock market returns may not match the underlying business fundamentals. The speculative return is evident in a stock’s P/E ratio. P/E multiples may rise or fall.

In the long run, whether for an individual stock or the total stock market, the market return must equal the investment return. Speculative return becomes statistical noise. Basic economics governs. Therefore, you do not need to forecast the speculative return; you only need to compute investment return.

Benjamin Graham stressed that the key isn’t whether an industry will be transformational or whether a company will grow. “Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors.”8

Similarly, Warren Buffett states,

The most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn…. [An] owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. Indeed, owners must earn less than their businesses earn because of “frictional” costs.9

[INSERT CHART OF INVESTMENT RETURN V MARKET RETURN 1900-TODAY]

Since 1900, the average annual total return of equities is 9.5%. Of this, the investment return was 9% including 4.4% from dividend yield and 4.6% from earnings growth.10 The difference between the 9.5% total return and 9% investment return is a 0.5% speculative return.

Of course, it is possible for stock market returns to exceed intrinsic value. However, when that happens, reversion (or regression) to the mean, requires the inevitable correction. For historical examples, see here.11

Given that speculative return amounts to a rounding error in the long term, by definition, speculators as a group will receive capture significantly less than the gross return due to their trading costs. To the extent that you incorporate speculative returns into your future projections about the price of a given equity (or the overall market), your long-term expectations are flawed.

Historical Return

Following are examples of historic real returns of assets:

• US Treasury bills are among the safest investments. While academics consider them to be “riskless”, their average annual return, adjusted for inflation, is essentially zero.
• Long term corporate bonds pay higher interest, including a “maturity premium” and a “default premium”. Adjusted for inflation, long term corporate bonds’ average annual return is 1.5%.
• Stocks have no guaranteed return, like bonds do. Therefore, they must pay a higher return than bonds. Adjusted for inflation, stocks’ average annual return is about 6.7% overall.

Expected Return

The expected return is the projected return of an investment after accounting for the risk of that investment. The Gordon Equation permits you to estimate future returns:

• for stocks, add the dividend yield of the market to the expected per-share growth rate, and
• for bonds, subtract the default rate from the interest rate. Both provide reasonably accurate forecasts of long-term results.

Actual future returns may not match expected returns, particularly in the short to medium term. Earning the expected stock market return requires fortitude. You should not sell equities when the markets dip. Seek comfort in statistics, especially the bell curve. Over time, markets will revert to “normal”.

Summary

Coming soon!

For More on this Topic

 

Updated on January 28th, 2019