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The Three Pillars

Stories tell of ancient Roman engineers standing under their newly constructed arches as the capstone is placed into position: a testament of the engineer’s accountability and understanding of the structural components needed to hold up the arch. Whether this story is true or not, many of these Roman arches remain standing to this day…

In investing, a shareholder’s total return is a function of three factors (or pillars): dividend yield, earnings growth and the change (expansion or contraction) of the price-to-earnings multiple. The contribution of each factor to the total return is subject to constant change. Therefore having an understanding of each factor’s past and expected future contribution is important in establishing realistic return expectations. In this article, we will discuss each of these pillars, with the goal of framing our expectations on which pillars will support the total return “structure” going forward.

Pillar One: Earnings Growth

The earnings power of a company is essential to providing long-term returns. This earnings power is most ideal when supported by a strong competitive advantage that affords the company significant pricing power, little competition and a financially sound balance sheet. It is all about the sustainability and resiliency of the earnings and the ability for the company to grow them in all economic conditions. These companies will see their share prices rise in tandem with growing earnings.

Pillar Two: Dividend Yield

When it comes to capital allocation a company has two options: it can retain and reinvest 100% of its earnings back into its business or it can pay out a portion of its earnings to its shareholders in the form of a dividend. Some companies that retain all their earnings may do so out of necessity for survival, while others believe they can create more shareholder value by investing excess cash in other opportunities for a higher return. Companies that chose to pay out a dividend, so long as the dividend is sustainable, are providing their shareholders with a fairly reliable source of return.

The most ideal dividend paying companies are those that maintain a financial position which allows them to generate enough earnings to support a healthy/growing dividend while maintaining existing operations and re-investing back in the business for continued growth. This can be a very rewarding cycle for an investor where the dividend yield can be counted on as a relatively safe and reliable form of return. Dividend yield should be thought of as the sturdiest of the three pillars; providing support for which the other two pillars can rely and be built upon.

{A dividend yield is the annual dividend distribution divided by the current price of the stock. For example, a company that pays an annual dividend of $0.25 with a stock price of $10 would have a dividend yield of 2.5%}

Pillar Three: P/E Multiple Change

The forward price to earnings multiple is the current stock price divided by next year’s expected earnings per share (net income divided by the number of shares). It is a measure that indicates how much an investor today is willing to pay for future earnings and is a function of many items such as the perceived risk in realizing those earnings, expectations for future growth, the relative attractiveness of the investment to other options or just pure irrationality. A rise in this multiple if earnings are held constant, means the market is putting a higher value on those earnings; maybe because they are considered stable and predictable in an unstable environment, or maybe it is just because the market in general is going higher. Ultimately expansion of multiple without earnings growth warrants caution unless the company was undervalued to begin with.

{Example: Company A expects to earn $1 in earnings per share next year and currently has a stock price of $10. This means the P/E multiple of Company A is 10x. If, for one of the many reasons listed prior, the P/E ratio increases to 12x, with no change in earnings, this would imply a “new” stock price of $12, or a 20% appreciation.

Over the past six years, the return in the stock market has been well supported by a rising P/E multiple; increasing from 11x in 2011, to 18x now. Given today’s elevated multiple, questions have been raised regarding what the exact justified P/E multiple should be. Does this multiple have room for continued expansion; further contributing to shareholder returns?

It is important to understand the building blocks that allowed this multiple to expand in recent years and to try and determine just what the correct multiple should be given where interest rates are (i.e. versus the alternative of investing in a risk free government bond). To do this, we find the equity risk premium most useful.

The Capstone: Equity Risk Premium

The equity risk premium (ERP) is the extra return a risk adverse individual requires to invest in equity (stocks) over a risk-free option such as a U.S. government bond. It is calculated as the inverse of the P/E ratio (earnings divided by stock price; otherwise known as the earnings yield) minus the yield of a risk free investment (U.S. 10 year government bond). The rationale behind ERP is that riskier investments demand higher expected returns to compensate the investor for this increased risk. It is a reflection of how much risk is inherent in the market and what “price” is attached to that risk. When equity premiums rise, investors are charging a higher price for risk which translates into paying a lower price for that investment. If you believe the stock market is overvalued, the equity risk premium would generally be considered as being too low.

Currently, the ERP has been on a downward trajectory due to a rising P/E multiple. Circled below is where we are today: 5.4% earnings yield, 2.4% U.S. 10 year government bond yield equating to a 3.0% equity risk premium.

The low ERP means investors today are demanding less risk premium for investing in equities than in recent years. As interest rates move off their rock bottom levels, the sustainability of today’s elevated multiple has been called into question. As rates increase, the multiple should contract. The table below charts the “justified P/E” based on different scenarios [today’s multiple outlined in red]. If the risk free rate rises, as it’s likely to do, the justified P/E ratio would decline unless it is offset by a lower risk premium. During the period 2003-07, the average ERP was 2%. If the ERP were to decline back to this pre-financial crisis level and interest rates rise to 3%, this would imply a justified multiple of 20x. However, if rates rise to 3% but investors remain equally risk adverse the multiple would decline to 16.7x, negatively affecting investor’s return.


So will the arch collapse without the support of Pillar Three? This depends on the sturdiness of Pillar One and Pillar Two.

Dividend yield and earnings growth will play an increasingly important role in the contribution to future investment returns. Meaning companies that are capable of growing their earnings and paying an increasing dividend are paramount in shielding investors from the potential negative impact of stagnant or contracting multiples. Positive future stock returns will come from investing in companies that offer earnings growth and a dividend yield high enough to offset a potential decline in its multiple. The days of an investor riding the overall tide of the market via multiple expansion are now likely behind us.

Investors who are unafraid of risk will fail to accept compensation for this risk. Overly optimistic investors will pile into stocks regardless of the multiple or bonds irrespective of their low yields. When this is the case, it is important to remain rational and remember the structural components of the three pillars. When any of the pillars fail to support its weight, the other pillars must pick up the slack or else the arch will undoubtedly crumble.

The Summerhill Team

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