Breaking down the total returns by source, helps you understand perfectly how total returns are generated
Total Returns are a function of:
1. Dividends
2. Earnings Per Share Growth
3. Change in valuation
The first two items matter the most in the long run; the last matters the most in the short run.
Ultimately, the trade-offs between each item on a given time period determine total returns overall.
As Benjamin Graham aptly summarized it, "In the short-run, the market is a voting machine. In the long-run, the market is a weighting machine."
I recently found a chart that breaks down S&P 500 returns by decade, starting in 1880 and ending in 2019.
It's fascinating to understand how annualized total returns were generated by looking at the interplay between those sources of returns.
For example, during the first decade of the 2000s, total returns were driven mostly by dividends, as share prices declined due to multiple's decreasing. Earnings growth was muted as well. This is when a lot of investors realized that trees don't always grow to the sky.
The 2010s however showed a completely different picture. The dividend portion of total returns was smaller and overshadowed by changes in earnings growth, and aided slightly by changes in the multiple.
Overall, changes in the multiple tend to produce big swings in the positive or the negative direction. However, these tend to revert to the mean over time. Ultimately, the longer your timeframe, the lower the impact of multiple changes on total returns. However, the shorter the timeframe, the higher the impact of the multiple changes on total returns. However, be advised that multiple changes are properly titled as "speculative" source of returns. That's because it's heavily influenced by the short-term views of Mr Market.
For example, in the 1970s, valuations multiple shrank, which subtracted a steep 8.30%/year from annualized returns. Paying a high valuation in the late 1960s turned out to be a headwind to shorter term returns. While a decade is "short-term", holding through a painful decade definitely doesn't feel short-term.
However, in the 1980s, valuations expanded, which added 8.20%/year to annualized returns. It's definitely a good situation to be in when you can buy stocks on the cheap, and then they deliver earnings growth, solid dividends and the multiples expand too.
This type of a model is directly applicable to studying individual companies as well. This is why I find it helpful to evaluate dividend growth and earnings growth for each company I review, and then also review that in tandem with valuation multiples such as dividend yield and P/E ratio. It's important to look at the bigger picture, and not get stuck on one item however.
Thank you for reading!
