If you aggregate the 500 companies in the S&P 500, by market capitalization, you can look at the S&P 500 as a big holding company representing complete ownership of all the underlying 500 companies. Doing so on September 1, 2011 would tell you, for example, that the TTM (trailing twelve month) P/E ratio for the S&P 500 is 13.7, which means your company has earned 7.3% on every dollar you invest, of which 2.1% was paid out in dividends (29% payout ratio) and the rest re-invested.
As Warren Buffett wrote about in the seventies (link), the re-investment adds to book value, and ideally gets some incremental return on equity (ROE) on your behalf. What is the ROE of the S&P 500 right now? You can figure it out with the same aggregation process as above. As of September 1, 2011, the ROE of the S&P 500 was 13.8%, and the Price-to-Book is 1.9.
The first graph below shows how the ROE has behaved over almost 2 years, with the early low points obviously caused by the drop-off (and write-offs!) in earnings during the credit crunch. You can see that the earnings have bounced back well, although many seem to be concerned about how long it will last. It is interesting to see the number hovering near the 12% that Warren Buffet mentions in his article so long ago.
So, investing in stocks right now gives you 2.1% in dividends and lets you re-invest another 5.2% into a 12-14% coupon. That's a pretty good deal, especially when contrasted with 2% coupons for US Treasuries and not much more for high-quality corporate debt. Incidentally, it's not surprising to see that companies that have no real need of debt (like Google, Johnson & Johnson, and Intel) are all issuing debt at super low yields, and often buying back stock in large amounts.
One last part of analyzing ROE I want to present is this: you can also break it down into components - i.e. ROE = Net-margin * Sales-to-Assets * Assets-to-Equity. The second graph below shows these three components - you can see that all 3 (margins, asset turnover, and leverage) have improved over 2 years. To me this graph is underscoring that corporate balance sheets and earning power are doing well.
With all of these ways of looking at it, I'm having trouble seeing how you can do poorly investing in stocks, especially when contrasted with bonds. If the whole financial system is going to go under, maybe the gold bugs will triumph over everybody, but I don't see it.
As Warren Buffett wrote about in the seventies (link), the re-investment adds to book value, and ideally gets some incremental return on equity (ROE) on your behalf. What is the ROE of the S&P 500 right now? You can figure it out with the same aggregation process as above. As of September 1, 2011, the ROE of the S&P 500 was 13.8%, and the Price-to-Book is 1.9.
The first graph below shows how the ROE has behaved over almost 2 years, with the early low points obviously caused by the drop-off (and write-offs!) in earnings during the credit crunch. You can see that the earnings have bounced back well, although many seem to be concerned about how long it will last. It is interesting to see the number hovering near the 12% that Warren Buffet mentions in his article so long ago.
So, investing in stocks right now gives you 2.1% in dividends and lets you re-invest another 5.2% into a 12-14% coupon. That's a pretty good deal, especially when contrasted with 2% coupons for US Treasuries and not much more for high-quality corporate debt. Incidentally, it's not surprising to see that companies that have no real need of debt (like Google, Johnson & Johnson, and Intel) are all issuing debt at super low yields, and often buying back stock in large amounts.
One last part of analyzing ROE I want to present is this: you can also break it down into components - i.e. ROE = Net-margin * Sales-to-Assets * Assets-to-Equity. The second graph below shows these three components - you can see that all 3 (margins, asset turnover, and leverage) have improved over 2 years. To me this graph is underscoring that corporate balance sheets and earning power are doing well.
With all of these ways of looking at it, I'm having trouble seeing how you can do poorly investing in stocks, especially when contrasted with bonds. If the whole financial system is going to go under, maybe the gold bugs will triumph over everybody, but I don't see it.
What are the key drivers here?
ReplyDeleteAre margins higher because of a better product or is it because of lower costs as a result of layoffs?
OR
If cut back are causing higher margins, who is driving more demand for S&P's products?
Jeremy Grantham's Q2 article (part II) make some interesting points to explain the high unemployment, high savings rate, low consumer confidence vs such high levels of profitability for corporations.
He was proposing that cost reduction and increased gov't debt amplified profits but when this trend stops or perhaps reverses then margin compression would also be amplified.
The unfortunate part is that most gov'ts around the word are taking on more debt and most corporations in the S&P 500 are all part of this behaviour which Jeremy Grantham noted as being more like a Jim Jones situation than a NAFTA situation.