- Long-term CAGR from S&P 500 and Berkshire Hathaway define the lower bound and upper bound values
- Long-term ROICs from US non-financial industries are consistent with S&P 500 long-term CAGR
- Value investors should expect higher rate of return than average
As value investors, how much rate of return should we expect from our stock portfolios in long run? Some may say as much as possible whereas some may conservatively accept any rate higher than their cost of capital. I think we have better way to figure it out. It is also important to have a “reasonable” expected rate of return for at least two reasons:
- avoid being disappointed due to significantly lower than expected rate of return
- help us to make investment decision and personal financial planning
Yes, the keyword here is “reasonable”.
In this post, I intend to find out the reasonable expected rate of return from our stock portfolios in two approach: top-down and bottom-up.
Top-down approach: a reasonable rate of return should be somewhere between that of the index and the best performing value investor
Firstly, I define the lower and upper bound expected rate of return based on the long run rate of return from the index and Berkshire Hathaway respectively. The logic for lower bound is simple: we spend much time and effort on researching stocks, shouldn’t we expect higher rate of return than passive index funds? From Warren Buffett’s letters to Berkshire shareholders, we can conveniently check out the long-term rate of return from S&P 500 (with dividends included). From 1965 to 2016, S&P 500 generates a compound annual growth rate (CAGR) of 9.7%. Hence, if someone expects his US stock portfolio gives him a rate of return of 9% in the long run, then it simply does not worth his time researching stocks. For upper bound, few value investors would not agree that Warren Buffett’s over 50 years CAGR of 20.8% (mark-to-market) is the best benchmark.
Bottom-up approach: a long-term look at ROIC
What are the investments in S&P 500 and Berkshire Hathaway? Certainly they are equities. So, it is logical to research a large number of companies’ long-term return on invested capital (ROIC). I do not have time and resource to conduct this research. Fortunately, Bin Jiang and Timothy Koller from McKinsey & Company performed an excellent research on this topic back in 2006 . They collected the historical financial data of about 7,000 listed companies in US from 1963 to 2004, excluding financial industry . One of their key findings is relevant to the topic in this post:
From 1963 to 2004, the US market’s median ROIC, excluding goodwill, averaged nearly 10 percent. That level of performance was relatively constant and in line with the long-term cost of capital.
This 10% was the average of both cross-sectional (all non-financial industries) and longitudinal (40 years) ROICs; and it is consistent with S&P 500 long-term CAGR. It means that if we take average in both dimensions, we should expect around 10% rate of return in long-term. Other findings from Bin Jiang and Timothy Koller revealed the median ROICs among the industries. For example, software and services industry delivered a median 18% ROIC while utilities industry generated only 7% ROIC. In addition, their findings detailed the variations within the industry. For example, software and services industry had a spread between the top (75th percentile) and the bottom (25th percentile) companies averaged around 31%. By contrast, utilities had merely 2% spread.
How much rate of return should we value investors expect?
We should NOT expect average rate of return of 10% from our stock portfolios. Rather, we should expect higher than average. This is because value investors do research and buy only a handful of stocks from few industries within our “circle of competence”. Moreover, we buy bargain stocks due to market mis-pricing. Surely everyone of us has a different judgement on our long-term expected rate of return within the lower bound of 10% and upper bound of 20%. My judgement on the expected rate of return of my stock portfolio is around 15%. How about yours?
 Bin Jiang and Timothy M. Koller, “Data focus: A long-term look at ROIC,” The McKinsey Quarterly, Number 1, 16-19, 2006
 The financial crisis two years later after their research proved that they were very right to exclude financial industry. The high ROICs of financial industry was simply not sustainable and some of their businesses did not contribute to economic welfare to our societies.
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