Classic Bernstein 10 — Economic Growth and Stock Dilution

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Classic Bernstein 10 — Economic Growth and Stock Dilution

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PREFACE: This is the tenth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?, 5-What’s a Thing Worth?, 6-The Value Premium & Inflation, 7-The Great Fund Fee Mystery, 8-Is Credit Risk Ever Worth Taking?, 9-The Stock Returns Fairy, Exposed
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Does rapid economic growth lead to rapid stock price appreciation? Many investors, both beginning and seasoned, are attracted to the idea of investing in rapidly growing economies, such as emerging or frontier markets, in the belief that they’ll realize exceptional stock market gains. In this analysis, Mr. Bernstein examines the relationship between GDP growth, earnings growth and stock prices — and arrives at an uncomfortable conclusion for such seekers of growth.

GDP and Earnings Growth. Using the example of the U.S. economy from 1929-2000 (with its fairly good data on GDP growth, corporate profits and stock market indexes), Mr. Bernstein first plots GDP growth and corporate earnings over the 70-year period (chart below). Except for the Great Depression, when overall corporate profits briefly disappeared, nominal aggregate corporate earnings growth has very closely tracked nominal GDP growth, with corporate earnings at a nearly constant 8%-10% of GDP since 1929. In fact, the two trend growth rates have been almost identical, within about 20 bps. Cannot stock prices also, then, be assumed to grow at the same rate as GDP?
Stock Dilution. The problem with this assumption is that per share earnings and dividends keep up with GDP only if no new shares are created. Entrepreneurial capitalism, however, creates a “dilution effect” through the creation of new enterprises and new stock in existing enterprises. Thus, per share earnings and dividends grow considerably slower than the economy.

Mr. Bernstein comes up with a remarkably simple method to measure this degree of slippage: the ratio of the proportionate increase in market capitalization to the proportionate increase in market price. For example, if over a given period, the market cap increases by a factor of ten, and the cap-weighted price index increases by a factor of five, then there has been 100% net share issuance in the interim. This relationship factors out valuation changes (as they are embedded in the numerator and denominator) and holds only for total market indexes such as the Wilshire 5000 or CRSP 1-10. In the chart at left below, Mr. Bernstein plots the total market cap and price index of the CRSP 1-10, with 1926 equal to 0:
Notice how the market cap slowly and gradually pulls away from market price. By the end of 2001, the cap index has grown 4.97 times larger than the price index, suggesting that for every share of stock extant in 1926, there were 4.97 shares in 2001! In the chart at right above, Mr. Bernstein plots this dilution index, showing the cumulative net creation of new shares. Note the nearly continuous net dilution of shares, growing rapidly in the 1920s, decelerating after the crash of 1929, and even contracting in the late 1980s, as companies responded to peak capital costs with stock buybacks. The overall rate of dilution from 1926 to 2001 was 2.15% per year.

What conclusions can we draw from Mr. Bernstein’s analysis?
  • a) In fast growing economies, entrepreneurial capitalism is constantly creating new enterprises and new stock in existing enterprises. As a result, per share earnings and dividends grow considerably slower than the economy.

    b) Stock investors can only participate in the growth of existing businesses and the shares that they own. Venture capitalists participate in the growth of new businesses.

    c) Stock dilution leads to a separation between long-term economic growth and per-share earnings growth and prices.
Thoughts?

PS. More details can be found in Mr. Bernstein’s 2003 paper (with Rob Arnott): Earnings Growth: The Two-Percent Dilution
Last edited by SimpleGift on Fri Jun 17, 2016 8:38 pm, edited 7 times in total.
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Re: Classic Bernstein 10 — Economic Growth & Stock Prices

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Just to add that stock dilution in some emerging market economies of the 21st century has been an order of magnitude greater than stock dilution in the U.S. economy over the 20th century (chart below). In economies with such heady growth rates, companies must constantly be raising new equity capital, diluting their per share earnings for existing shareholders.
In fact, if Mr. Bernstein was writing his paper today, it might be called “China: The Thirty-Percent Dilution”! The headline aggregate earnings growth of Chinese companies (in green below) has vastly exceeded the growth of their per share earnings (in orange). Profits are obviously growing, but they are spread across a shareholder equity base that is growing even faster.
Last edited by SimpleGift on Sat Jun 18, 2016 7:30 am, edited 1 time in total.
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Re: Classic Bernstein 10 — Economic Growth & Stock Prices

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This gets at some of my concerns about emerging markets.

Much as I'd like exposure to the dynamism of emerging market economies -- with their big labor pools and rapidly rising consumer classes -- certain other factors give me pause.

1. Questionable applicability of equity indexing
I do not believe that buying into an index fund weighted by market cap is the best way to gain exposure to emerging markets. These are "young" economies, many with recently-privatized versions of state industry. In many cases, the government (and its buddies) maintains a stake, and they tend to be people alongside whom one would rather not be a minority shareholder.

Additionally, some of these countries (esp. China) have experienced periods of irrational exuberance due to individual domestic investors practicing the sort of behavior that preceded our own crash in 1929. Why buy into the "big names" captured by an index fund, when their valuations are manipulated by governments which either hold a stake in them, or fear unrest when their voting public's shares go to zero?

2. Political Risk
OK, the US government shut down a couple years ago. It is a little rich of us to get up on our high horses about political dysfunction. But it remains unlikely that the US government will disenfranchise investors of their stake in private enterprises. This risk is significant in emerging markets, especially for resource companies and "strategic industries". One need look no further than Venezuela's expropriations of foreign assets (or catastrophic withholding of necessary permits) in the last several years.

Even where the government is OK financially, there is political hay to be made of expropriating foreign assets. I think Iran is an interesting investment prospect, but I would not like to have assets registered there under an American name during an election season!

3. Less efficient markets
Transparency, reporting requirements, corporate governance, etc. tend to lag in emerging markets. Company valuations are therefore less likely to reflect their true value. This may point to the utility of active management for certain markets, but I don't reckon myself a very good fund-manager-picket.

All the same, my EM target allocation is 10% (VWO). Has anybody got a different way of doing this? Sovereign debt rather than equity, perhaps?
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Re: Classic Bernstein 10 — Economic Growth & Stock Prices

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People seem to overpay for growth, whether it's at the individual stock level or at the country level.

Dave
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Re: Classic Bernstein 10 — Economic Growth and Stock Prices

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How is this different than the long run return of 7% for stocks over 2 centuries?
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Re: Classic Bernstein 10 — Economic Growth and Stock Prices

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PeteyDink wrote:How is this different than the long run return of 7% for stocks over 2 centuries?
My understanding is that Mr. Bernstein isn't addressing the long-term return of stocks in this analysis, but rather the relationship between economic growth and per-share earnings/dividend growth. In the paper with Mr. Arnott, using the Dimson, Marsh and Staunton global database of 16 countries from 1900-2000, they calculate that real per-capita GDP growth averaged 1.9% for the century, while dividend growth averaged -0.5% — meaning an overall dilution rate of 2.4% (1.9% less -0.5% = 2.4%).

Thus stock dilution at 2% in the U.S. has not been unique and is in line with the global average of developed markets.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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Say a company returns 10% in one year, before dilution. The company capitalizes equity and awards new shares, causing a dilution "slippage" at the average rate of 2%.

The total diluted return is 9.8%.

Is this correct?
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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Well, dilution occurred in emerging countries in the past, and will continue to do do in the future. This is an unavoidable consequence of economic growth. And yet past returns PER SHARE of emerging markets were significantly better than developed markets. In other words, high dilution isn't necessarily a problem. I fail to see the point being made?
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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PeteyDink wrote:Say a company returns 10% in one year, before dilution. The company capitalizes equity and awards new shares, causing a dilution "slippage" at the average rate of 2%.

The total diluted return is 9.8%.

Is this correct?
2.0000% slippage/dilution estimate -minus- 10.0000% ROI = A 8.0000% estimate. Thats my understanding. Minus inflation(real), minus other variables = a returns estimate compared to a worst returns estimate. afaik. Great summation SGift! Good luck!
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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A complete list of Simplegift's series is in the wiki: Classic Bernstein
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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siamond wrote:Well, dilution occurred in emerging countries in the past, and will continue to do do in the future. This is an unavoidable consequence of economic growth. And yet past returns PER SHARE of emerging markets were significantly better than developed markets. In other words, high dilution isn't necessarily a problem. I fail to see the point being made?
I believe the point is a cautionary one, that investors should not “bet the farm” on emerging markets or other high-growth economies in the expectation of exceptional stock returns. Since rapid economic growth doesn't necessarily guarantee rapid stock appreciation, investors are better off with just a market-weight allocation (about 10%-15% of global equity today) or, at most, a modest overweight to emerging market equity.

In short, don’t get carried away with the economic growth story about emerging and frontier markets.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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Simplegift wrote:I believe the point is a cautionary one, that investors should not “bet the farm” on emerging markets or other high-growth economies in the expectation of exceptional stock returns. Since rapid economic growth doesn't necessarily guarantee rapid stock appreciation, investors are better off with just a market-weight allocation (about 10%-15% of global equity today) or, at most, a modest overweight to emerging market equity.
I don't disagree with a word of caution to investors about emerging markets, but I don't see what this has to do with dilution factors. With a healthy enough GDP growth, then what was left after dilution provided a hefty premium in past returns, and I don't see why this would be different in the future. If B is high, it doesn't follow that A-B is low, it all depends on A...

The reasons to be cautious about emerging markets are different in my opinion (e.g. high volatility, very long cycles with go-go decades and dire decades, currency risk, country-specific concerns about China, etc).
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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sps94 wrote:All the same, my EM target allocation is 10% (VWO). Has anybody got a different way of doing this? Sovereign debt rather than equity, perhaps?
There was a Forum discussion last summer on substituting emerging market bonds for emerging market equity, found here. Though EM bonds have surprisingly outperformed EM stock over the last two decades, I believe the consensus is this was due to factors unlikely to repeat in the future — namely, widespread credit upgrades (as emerging countries “emerged”) and the steadily falling interest rate environment of the past decades. But who knows.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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I’m made aware that, in another thread, Mr. Bernstein recently commented on his 2003 paper (Earnings Growth - The Two-Percent Dilution, with Rob Arnott) — so wanted to add his current remarks to this thread:
Bill Bernstein wrote:Yes, we're still diluting, but more slowly, perhaps the "new normal" is more like 1%, not 2%. (Rob keeps these data, and it's been a bit since I've peeked, but that was my eyeball of it last I did.)

What this tells me is not to worry too much about economic slowing harming stock returns. Yes, Virginia, long-term (real) economic growth may be more like 2%, not the historical 3%. But dilution is also off by 1%, so no harm, no foul.

Another way to to put this is that the economy is growing more slowly, and so needs to raise less fresh capital with which to dilute existing shareholders.

Bill
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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I want to think an index fund represents the output of a country. But I understand from this analysis it only represents the proportion of ownership of companies listed in the index. That proportion can be diluted by extra shares being given out or by new companies. A huge stock payment to a CEO hurts me but that might not be as big a factor as the next part. I cannot easily invest in Facebook pre IPO. I cannot invest in Apple when it was run out of a garage. I can only invest in them now. I wonder what percentage of companies are small and dynamic in EM vs more established markets.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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It is my understanding that stock buybacks are much more heavily used today as compared to the early years of the dataset (1920s, etc.). If that is true, does that change the analysis and conclusion? Should analysis be done on the data from the last 30 years or whatever the period is where stock buybacks are more prevalent?
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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qwertyjazz wrote:I want to think an index fund represents the output of a country. But I understand from this analysis it only represents the proportion of ownership of companies listed in the index. That proportion can be diluted by extra shares being given out or by new companies.
Yes. In a recent IMF publication was the chart below, showing the total capitalization of all emerging market stock (in blue) and the portion that was actually available for investment in the MSCI global indexes (in red). Granted, the MSCI indexes do not yet include any China mainland shares, but it appears that nearly half of all emerging market equity today is not investable — that is, held by private investment groups, or government agencies, or otherwise restricted by liquidity, etc. And the proportion of non-investable shares has grown significantly over the last decade, despite increasing globalization.
carolinaman wrote:It is my understanding that stock buybacks are much more heavily used today as compared to the early years of the dataset (1920s, etc.). If that is true, does that change the analysis and conclusion? Should analysis be done on the data from the last 30 years or whatever the period is where stock buybacks are more prevalent?
It’s likely that the net share buybacks in recent decades have decreased stock dilution in the U.S. market. As Mr. Bernstein indicates upthread, the current dilution rate may be more like 1%, rather than the historical 2% rate.
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Re: Classic Bernstein 10 — Economic Growth and Stock Dilution

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Bill Bernstein wrote:Another way to to put this is that the economy is growing more slowly, and so needs to raise less fresh capital with which to dilute existing shareholders.
More growth, more dilution. Less growth, less dilution. This makes perfect sense. And reinforces my "A-B" point above.
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