The Most Important Investment Tool In Your Lifetime

The father of value investing, Benjamin Graham, famously said, “In the short run, the market is a voting machine, but in the long run it’s a weighing machine.” This adage could be true for marriages, political campaigns and is especially true for the stock market.

There are two factors that drive the stock market over time:

Earnings and dividends.
How much investors pay for those future earnings in the form of valuation.

Tip The Scale In Your Favor
Earnings and dividends are the weighing machine since they tend to increase and compound over the longer-term making their future growth more predictable and important. This is especially true for large, diversified companies where earnings are not highly susceptible to fluctuating economic conditions and commodity prices. This would be the case for a large diversified healthcare company versus an oil production company.

Valuations, on the other hand, act as a voting machine and can be very unpredictable since they largely reflect investor moods especially shorter-term. Valuations in the form of the stock market price-to-earnings ratio (P/E) can change wildly due to uncertainty over Federal Reserve Bank monetary policy, Presidential tweets, inflation, trade wars etc. The P/E ratio is essentially a measure of how expensive a stock or market is compared to its earnings. A higher P/E ratio generally corresponds to an overvalued market and a lower P/E an undervalued market.

Unlike earnings, P/E ratios don’t compound higher and instead generally trend in a range over time. As the chart below highlights, the stock market P/E ratio has swung dramatically higher and lower while averaging about 17x since 1990.

“Time Is On Your Side When You Own Shares Of Superior Companies” – Peter Lynch

Corporate earnings and dividends grow and compound higher driven by factors including population growth, productivity, new products and acquisitions. However, since valuations (P/E) don’t compound higher, the importance of valuation on your portfolio diminishes over time. That’s actually a good thing for investors since trying to forecast what valuation to assign to the stock market is one of the hardest and most unpredictable parts of investing.

The chart below shows how valuation diminishes in importance as earnings and dividends increase and compound over time. In this example, valuation multiples (in red) swing up and down by 20% however earnings and dividends (in green) compound higher and higher. So, valuation’s influence on market returns diminishes over time as earnings and dividends grow in importance.

Over the shorter term, generally five years and less, there has been a negative relationship between valuations (P/E) and future stock returns. Meaning, as P/E trends higher, future market returns go lower and vice versa. As the chart below shows, as stocks get more expensive with higher P/Es (X axis in chart), the future market return (Y axis in chart) measured in real returns (after inflation) drops. The solid blue line in the chart highlights this negative relationship.

Now, lets’ see what happens to this negative valuation and market return relationship as we extend the investment time horizon (your important weighing tool!). As the graphic below shows over time, the negative relationship of P/E and future market returns diminishes as time extends from 5 years to 10 years and much more over a 20-year horizon. In fact, as the graphic shows, over a 20-year horizon, the stock market has not experienced a negative return even after accounting for inflation.

“Only buy something that you’d be perfectly happy to hold if the stock market shut down for 10 years” – Warren Buffet

As investment time marches on, the unpredictable voting machine of valuation has less and less impact on your retirement portfolio while the powerful weighing tool of time enables earnings and dividends to compound in your favor. To add weight to the scale, consider proven low-cost mutual funds and/or stocks with proven and consistent earnings and dividend growth. Like Warren Buffet says and practices, use the powerful tool of time along with patience and compounding to tip the scales more and more in your investing favor.

David Hone, CFA