Stock Market Returns: Five-Factor Analysis and What Lies Ahead

In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and John Rotonti Jr discussed Stock Market Returns: Five-Factor Analysis and What Lies Ahead:

Tobias: JT, you want to do-

John: Veggies.

Tobias -veggies?

Jake: Veggies time. Absolutely.

Tobias: Market boys, six minutes past the hour.

Jake: [laughs] All right. So, a few years back, we explored the ingredients behind stock market returns with the help of our friend of the show, Christopher Bloomstran of Semper Augustus and his five-factor analysis. His letter came out weekend before last. Clocking in, I think 160 pages. Wasn’t light reading necessarily, but it’s always good. I made it through it.

So, I wanted to update a little bit on pulling some of the numbers from the most recent that he did and giving everyone an update on it, because I think it’s interesting. So, if you remember, those five factors are sales growth, change in profit margin, change in share count, change in the multiple and then dividend yield. Four of those five factors depend on the business’s results, which are largely maths, and understanding and maybe more science, let’s call it. And then, the last is psychology, market psychology, which is how excited do investors get about the business’s future.

I can’t help but wonder actually if that how you should spend your time might be roughly correlated to that 4:1 ratio. Should you be thinking about the businesses, four times to the one time that you’re spending, like messing around with the market and worrying about where it’s going.

However, let’s keep going. In our previous analysis, we unpacked how there was a really, really strong decade from 2011 to 2021. It produced a 16.6% annual return, to be specific. And that came from the attribution of this was 3.4% from sales growth, 0.7% from share reduction, 3.8% from margin improvement, 5.8% from multiple expansion and then 2.3% from dividend yield. You add all that up and it’s 16.6. Okay.

Fast forward today, we’re going to be using Chris’ numbers for these things to give us a new recipe. This is what did the returns look like over the last couple of years using this analysis. So, 2022 was a reality check for everyone. The S&P fell 18.1%. The business results were actually not that bad. Sales per share grew at a robust 11.9% for that year. But that didn’t save you. The index plunged, because profit margins slipped from their peak and the PE multiple dropped pretty considerably.

So, margins fell about 15%, which is 13.3% going to 11.2%. And then, the PE went from 22.9% to 19.5%. So, that double hit the company’s earning a bit less on each dollar of sales and investors paying less for each dollar of those earnings drove the bulk of 2022’s loss. So, then came 2023 and 2024, which together were a big rebound. The index surged 26.3% in 2023 and then 25% last year. So, what caused this sharp recovery?

Well, largely, it was just a resurgence of investor enthusiasm. Over those two years, more than half of the total return was just PE multiple expansion. We closed the year at 25.2% at the end of 2024. In other words, basically, prices rose faster than earnings did. To be fair, the business fundamentals were decent. From the start of 2022 to the end of 24, sales grew at a total of 13.8% cumulatively, which is a 6.7% per year. And margins recovered a little bit from the 2022 drop, and they went back up to 11.8% for the yen. But we’re still below that 13.3% high water mark of 2021.

So, surprisingly in all this, the overall share count of the S&P 500 rose modestly over those two years. The companies, by the way, were spending billions of dollars on buybacks that whole time, and yet the net share count increased by 1.2%. This is due to the stock issuance, outpacing the purchases. So, all that stock-based comp that people are worried about, it actually does matter to you as an owner over time. Those buybacks that were done in the 2010s, those were relatively accretive, but we just barely kept up to keep share count in check. So, most of the market’s gains came from PE expansion, and it wasn’t really necessarily earnings or economic output.

So, what I would say that kind of driver of returns like market expansion can be fickle, like what Mr. Market giveth he can taketh away as well. So, where does that leave us for the remainder of the decade? This is where you should probably start to get interesting. In 2021, stocks were priced for perfection. And after a round trip in 2024, they’re again priced at close to perfection, like pretty high levels. Unless these business fundamentals somehow continue to surprise to the upside, it’s hard to see the index delivering anything close to that very juicy 16.6% that we had that decade before.

So, Chris has a few 10-year forecasts that we’ll run through real quick and plugging in various assumptions into this five factor model. You can do your own work on what do you think is reasonable and come at your own conclusions. So, in Chris’ call it a rosy scenario, he assumes that margins and multiples return to that 2021 level. You get 3.4% from sales growth, which is just call it GDP. You see a bit of share count reduction and some dividend yield. And you add it all up and you get a 5.7% per annum return, if you go out to 2034. Okay.

He has another one that’s call it like a reversion to the mean scenario. It’s not that far-fetched, I don’t think. But assume that you go back down to an 8% profit margin profile, which by the way, is still a couple points higher than the long term 6% as put forth by Buffett and Grantham.

Tobias: A bit lower than we’ve seen for quite a few years now.

Jake: Yes, it is a bit lower than we’ve seen for quite a few years, which may have been goosed by trillion-dollar deficits, but I digress. And then, plug in a 15x market multiple which is more like the long-term average. So, we’re just reverting towards the mean a little bit on some of these things.

You still get credit for 6% sales growth, which I think personally might end up being a little high. You still get a 1.7% dividend yield and assume no change in share count, which may or may not be true. But that result is then in 2034, you’re sitting 14.2% lower than you are today on the index 10 years from today, which is a minus 1.5% annualized, a lost decade similar to the 2000s.

In the last scenario, which is imagining that at some point in the history of the world, you have to spend some time under the mean, which I know is totally unrealistic. So, just throw this in the garbage. But let’s say you get that same 6% sales growth and an even higher 2.2% dividend yield, and you assume that the margin is going to that 8% again, which you know, we could even take that lower. But then, assume that the PE multiple goes to 10x which I know no one can imagine that when you’re sitting at 2025 today. There’s been lots of times in history when you’ve been at a 10x multiple for the market.

In this very sobering assumption set, you’re 42.5% lower a decade hence, which is a 5.4% loss per year over the next decade. I’d say that this might not even be the worst-case scenario. If we imagine that stagflation that we were talking about before, you don’t get 6% sales growth, but you do get the even worse margin compression as businesses can’t raise their prices on an already ailing consumer despite their input costs levitating. I would make the argument, like maybe we’re $150 oil away from this becoming a very realistic scenario.

So, then, imagine that these companies might also have to issue equity at some point and dilute you in order to survive, maybe as part of some government bailout scheme. We’ve seen that before. One does not need a particularly fertile imagination to paint a quite oblique picture from here.

So, anyway, you’re free to plug in your own numbers into all of this, and maybe you end up with a better expected outcome. But what you probably shouldn’t do is just draw a linear extrapolation off of the last decade and line up– which was a line that just went up and to the right. I think it’d be wise for all of us. Munger said this continuously was, “You should temper your expectations. The next stretch of the track might be a bit muddy. Maybe the easy money of the last decade likely won’t repeat this coming decade.”

As always, we’re talking about the overall market here. Within it, there will be individual opportunities, individual intelligent things to do if you’re disciplined and patient and selective in what you’re doing. But that’s it for today’s veggies. Perhaps, a little bit bitter in the aftertaste, but that’s how proper medicine often is. There’s a little [Tobias laughs] bitterness to it.

Tobias: What do you think, John?

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