Q1 2023 Update – The Fundamentals of Long-Term Investing
First Quarter and YTD Market Returns
*Data provided by Y-Charts as of 5/9/2023
In Q1, The Wilshire 5000 gained 6.82% and was up 7.08% as of 5/09/23. A good start to the year and a rebound so far from the 2022 declines.
The Barclays Aggregate Bond Index increased 2.73% in Q1 and was up 2.17% as of 5/09/23.
5-year rolling returns as of 5/9/2023 show the Wilshire 5000 up 50.52% and the Aggregate Bond Index down -6.24%.
Long-term returns for the patient and disciplined equity holders continue to perform in line with or above our expectations. To the extent we might be facing a recession or choppy times ahead it’s very important to continue a long-term focus and follow your plan. We expect more turbulence to come, but the plan is set up well to weather the storm in accordance with your risk and ideally capture more long-term opportunities
The biggest killer of long-term financial planning is emotion! Market timing and ill-timed plan changes born out of emotion can hold large consequences. They are usually based on short-term thinking that we desperately try to avoid by planning in the first place.
To this extent, I have dedicated this quarter’s article to educating on the fundamentals of investing. This is a slightly different approach than most quarters in hopes you gain a confidence boost from a revisit of fundamentals and timeless investment quotes from the legends. Remembering why long-term investing works is a huge key to success! Enjoy.
Investing 101 – Fundamentals of Long-Term Investing
To be a great investor you must understand the answer to 1 question well; Where do returns come from in the long term?
“The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits.” Seth Klarman
So, Where do returns come from?
If no magic formula exists, then where exactly do returns come from and how can an investor be successful? The answer lies in the simplicity and math of long-term compounding.
“The elementary mathematics of compound interest is one of the most important models there is on earth.”
Here is a great example of compounding. Given the choice between taking $1 million or doubling a penny every day for 30 days…you would be wise to take the penny that doubles. In the end, you would have $5,368,709.12 rather than $1 million. All you have to do is wait 29 days more and you end up 5x richer. An extreme example that highlights the power of compounding for sure.
I challenge you..ask yourself if you would take the penny? It’s easy in hindsight or if we know the exact compounding rules will play out, but what happens if things get uncertain? We know most people take the $1 million in real life rather than trusting the science of compounding. It’s easier to take the upfront money, the one they can see here and now. Taking the penny without a hindsight bias requires faith in compounding. You must believe that it will compound at a rate that leaves you much wealthier than taking the $1 million. This is a large ask for many people. Ultimately, it is the choice we make when we decide to invest in an uncertain world.
Thankfully we are not left to blind faith. We can see compounding happening consistently if we look under the hood. But we have to make sure we are looking in the right place. Looking at a daily stock price is simply looking at a daily occurring auction that reflects the emotions of the day rather than the actual compounding. Looking at a number that reflects daily emotion is a sure way to harness undue emotion and increase the odds we make a poor decision. Human nature when measured in aggregate becomes greedy at the wrong time, fearful at the wrong time, and lacks a great deal of patience and content. Imagine the penny doubled daily in real value but was put to an auction of people each day. That auction would sometimes value above or below. You would probably become an emotional wreck watching an auction and wondering if the penny will compound to well above the $1 million. This is exactly what the stock market does every year. In the end; success as an investor largely comes down to understanding an investment’s real compounding ability and ignoring the daily auction.
“The first rule of compounding: Never interrupt it unnecessarily.”
“It’s an easy game, if you can control your emotions.”
But what drives the compounding ability, to begin with? For the penny to double…the value must increase. Seems natural enough to understand…2 pennies are worth more than 1. When investing in companies (equities/stocks) the value of our portion of ownership must increase for compounding. The value increase is not the daily auction price quoted by the stock market as many would lead you to believe, but rather the fundamental value the business gives each owner. This value is best represented as earnings per share or you could think of it as profit per owner. Since each stockholder holds a right to the business they are the owner and own a proportional claim on the business according to the amount they own. If you think of the profit as taking the penny that doubles…it is the company’s profit increasing over time that creates the compounding magic for investing. The answer to where returns come from is easy…profit over time! This should be principle 1 for all long-term investing: own companies that have profits and can grow profits over a long time. Without this focus, you are no longer investing and the penny is not required to double. Without profit growth, you are reliant on human emotion and selling to someone who is often more emotional than you. A good example would be the crypto craze of 2021 and people scrambling to buy unlimited supply coins with no profit production. This shows the opposite of investing. There was no real value or compounding ability and the only real value was the daily market auction itself and a reliance on human greed to keep it going. These are not investments. Investments have real profit and cash flows belonging to you as an owner with a real compounding ability regardless of the daily stock market auction price.
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
–Benjamin Graham, The Intelligent Investor
For compounding to occur we do need profits per owner to increase. This can happen in several company-specific ways such as revenue growth flowing to profits, cost cuts flowing to profits, or buybacks increasing our pro-rata ownership of the company. But in general, what gives us confidence they will increase on a more aggregate or macro level?
Here is a summary of the S&P 500 company’s real earnings per share over the past 30 years alongside the stock market as represented by the S&P 500 price over the same time. (Source: https://www.in2013dollars.com/us-economy/s-p-500-earnings)
|Year||Earnings Per Share||S&P 500 Price|
Earnings Per Share compounded 923% in the past 30 years and the S&P 500 Price gained 810%.
If we consider the S&P 500 dividends paid out you end up almost at an exact match. While the stock market daily auction is very emotional short term, it always reflects the compounding ability and profits long term. It is very scientific in its ability to match up over long periods (10,20,30 years). Investing is not throwing darts and hoping it lands, it is very much a profit-dependent science over long periods.
The list of emotional events in the past 30 years that caused the daily auction to disconnect from the compounding story includes the 1992/1993 recession, the 2000/2002 tech bubble bursting, the 9/11 terror attacks, multiple wars, geopolitical strife, various political administrations, the 2008 great recession, 2011 debt ceiling panic and shutdown, world pandemic, just to name a few. Meanwhile, the penny just kept on doubling!
If you need a little more proof to gain confidence in long-term investing; it may be wise to press harder about WHY. Why did the profits increase and why must they keep increasing long term? The answer lies in 2 main variables that fuel profit growth long term.
- Economic growth fueled by a desire for more
The purpose, motivation, science, and art of investing boil down to these 2 variables. We invest for only 2 reasons…capture inflation and economic growth over long periods of time. It is helpful to think about these 2 variables in simple terms using a lemonade stand analogy. If the lemonade stand produces $10 a week in profit selling cups of lemonade and the price of sugar increases by $2…what will the lemonade stand owner do? Charge $2 more or $3 more? Because the owner has inflation in his life and uses sugar outside the lemonade stand he needs to not only keep his profit of $10 but now demands more to help him pay the bills at home so he charges $3 and his profit increases to $11 ($2 more to pay for the sugar cost and $1 to pay himself more for his personal bills increasing). In this way, companies and owners adjust and demand the money needed to cover inflation. If we assume inflation will be positive over time and lacking price controls we can assume profits will grow with or above inflation over time. This leads to a deeper discussion on selecting and diversifying investments that have pricing power which is exactly what we do but a nuanced discussion for a separate article. Suffice to say…if we have inflation then we usually have profit growth long term.
Now, the second reason we invest is to capture economic growth. If we assume people will want…or need… more 10 years from now than today, economic growth should occur. Let’s say the lemonade stand customers work hard to save up and buy more cups next week because they enjoy it. The lemonade stand owner makes more money. He perhaps wants a bigger house and with more money contracts his neighbor to build who in turn has more money and now buys more lemonade…you get the point.
So, what happens in the rare instance profits do not increase long-term for the markets? This would mean either we experience deflation and/or long-term people desire and need fewer goods and services. If this occurred, think about what this means for your spending power. If we have deflation and/or long-term economic declines or stagflation then each of our dollars becomes more and more valuable and spending power increases (or at least does not erode) so you would need less and less money to live on. If living cost decline long term, then it is ok for your investments to decline long term as well or at least not go up as fast. Living costs declining by -2% a year for a long time and investments gaining 2% a year for a long time would be a 4% net increase in living experience which is the same as a 3% a year inflation and 7% investment return. The same is true for economic growth. If we experienced long-term economic declines, the price of goods would get cheaper and cheaper requiring less money to live or retire on. This should give us some level of confidence in long-term investing to know that even if it does not work out; if we are properly diversified then we still should achieve our financial plan to retire and maintain net spending power. While I think the odds of this happening are extremely low, we invest with this rare possibility in mind. A movement away from capitalism would become the likely reason for long-term deflation/stagflation / and economic declines without a rebound. Compounding would be greatly reduced, and the penny would not double as fast. But the penny would not need to double as fast because the living expenses should decline faster.
Let’s put this all together. Since 1992 Profits have compounded over 900%…the penny kept doubling through all sorts of crazy stuff. If I attempted to time multiple administrations, multiple rate cycles, tech collapse, great recession, wars, and a world pandemic…I would have failed miserably! Instead, we focus on the penny doubling and trust given a long enough period the compounding results in wonderful price gains. Over 800% returns in the past 30 years not even including dividends seem like a reason to keep investing in solid companies. If inflation and the economy keep growing then we expect reasonable results to continue long term. If inflation and growth subside then we are diversified to maintain lifestyle relative to the value of goods and living costs so you can maintain your lifestyle regardless. Up or down; investing works long-term and is designed very specifically to achieve your needs regardless of the many risks that are sure to come!
As always, we never know exactly what the future holds. The market will continue to go up and down to some extent in 2023. We remain laser-focused on real business values and aim to maintain a healthy group of investments that can compound in line with your long-term financial plan. If things worsen we will continue to opportunity seek for investments that align with your personal goals.
Let me again say THANK YOU! Our success together is an equal part great team, great advisors, and great clients. We feel extremely blessed to get up every day and do exactly what we love doing. If we did not serve such great families, we would not love what we do nearly as much. It remains a tremendous honor to steward your hard-earned assets and continue helping you meet your long-term objectives. Don’t hesitate to reach out if you have any questions or concerns.
Disclosures: (1) Data reported by Folio Institutional. (2) Data reported by Y-Charts Data, www.ycharts.com.
Index results such as the Wilshire 5000 and S&P 500 do not reflect management fees and expenses and you cannot typically invest in an index. Evergreen Wealth Management, LLC is a registered investment adviser. The information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.