Field of play
An element of compound interest
Stocks really do outperform all other asset classes. There are a few qualifiers. First, it only is true over the long haul. Second, the stock portfolio must be carefully chosen. And third, the portfolio must be balanced and diversified. But this is not the topic for today’s post.
The subject I look at today is ‘why’. The question is why stocks outperform other assets classes.
The nature of a common stock
As Jeremy Siegel has pointed out, in the nineteenth century, common stocks were thought to only be suitable for speculators. The proper way to ‘invest’ was in bonds. In the early twentieth century the idea emerged that common stocks might outperform bonds in times of inflation. But it was still thought that in times of deflation and disinflation, bonds were the only suitable investment. (Siegel, Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. 1998) p. 45.
In the 1920s the true nature of investing in common stocks compared to bonds was explored by Edgar Lawrence Smith, a financial analyst and investment manager. He published his ideas in a book in 1925. His book was titled Common Stocks as Long Term Investments. Jeremy Siegel refers to Smith’s book as exploding popular conceptions about the performance of stocks compared to bonds.
Smith’s observation was: “A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.”
Warren Buffett weighs in
On December 10, 2001 Carol Loomis’ report on the CNNMoney website contained an essay written by Warren Buffet based on a speech he had given the previous July. (Buffett W., 2001) See here.
Buffett wrote: “To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker–John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith’s most important point … and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus, there is an element of compound interest operating in favor of a sound industrial investment.’
Buffett continues: “It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.’” (Emphasis added)
High return on invested capital
In a nutshell, this guides us to the kind of companies/stocks we want to invest in. These are companies that both generate a high return on the capital (equity and debt) invested in the business and also have the opportunity to invest the free cash flow generated (excess capital) back into the business at high rates of return.
Philip Fisher’s take
Warren Buffett credits Philip Fisher as being, after Ben Graham, the greatest influence on his approach to investing. Fisher wrote: “If [investors] are saving any part of their income rather than spending it and if they have their funds invested in the right sort of common stocks, they are better off when the management of such companies reinvest increased earnings than they would be if these increased earnings were passed on to them as larger dividends which they would have to reinvest themselves.” (Fisher, P. A. Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p.118. (Emphasis added)
He adds: “Therefor, [the investor] is usually running less risk in having this good management make the additional investment of these retained extra earnings than he would be running if he had to again risk serious error in finding some new and equally attractive investment for himself. The more outstanding the company considering whether to retain or pass on increased earnings, the more important this factor can become.” (Fisher, 1958,1996) p.119. (Emphasis added)
Do you want high dividends?
And what makes sense for shareholders? “…you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p125. (Emphasis added)
An aside on total return investing
From an investor’s point of view, whether the return comes from dividends or capital gains or some combination of the two, makes absolutely no difference. You can live off your capital gains without depleting your capital if your total real return exceeds your expenditures.
What about bonds?
Since my default asset allocation is 100% stocks I make little use of bonds. I sold all my stocks in late 1998 and went 100% into two-year government bonds for five years. I did this because I had concluded by the late 1990s that the overall stock market was caught up in a wicked bubble, the kind that only occurs a handful of times in 100 years. There are two problems with bonds, inflation and higher quality means lower yield. With stocks, higher quality means higher returns.
Other asset classes
Gold and crypto are not investments. I have never touched them. Real estate is illiquid. All other asset classes available to individual investors are ‘products’ sold by the investment industry with big fees and low returns.
Conclusion
A lot of investors think a sophisticated and complex approach to investing is necessary to achieve superior returns. In my view, simplicity is the key. You can educate yourself through reading about investing and gain experience through hands-on practice. One simply looks for wonderful businesses that make lots of money and can invest back in the business for growth.
+++++++++++++++
Here are a few earlier posts that build on this topic:
My thoughts on asset allocation
Why an all-stock approach to investing makes good sense
Active investing is the only way to superior returns
The joy of higher return with no more risk
+++++++++++++++
You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
+++++++++++++++
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
+++++++++++++++
You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
+++++++++++++++
There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
If you like this blog, tell your friends about it
And don’t hesitate to provide comments or share on Twitter and Facebook