The Question of Value

It is one of the most important questions an investor should ask: What is the right price to buy (or sell) a security? Unfortunately, it is almost impossible to answer with any degree of certainty.

That does not mean, of course, that nobody has answers. Arguably, there are as many responses to this question as there are investors—and maybe even humans—in the world. Indeed, it is likely that anyone who cares has an approach or algorithm oriented towards this issue. These can include very simple methodologies based on one variable, such as whether one “likes” an investment. Most of us probably know someone—a spouse, perhaps?—who has perfected the use of this one-factor model. Some might even argue that there is much to be said for keeping things simple. 

But for many investors, this is not enough. Take the equity market, for instance. Most would probably agree that there are a variety of factors that not only influence the price of a stock, but perceptions about its value. Moreover, the way in which these factors interact with one another can create additional crosscurrents, including feedback loops, that affect attitudes and behavior. The number of variables, then, is truly infinite.

The sheer vastness of the data set and the challenges of finding a workable approach to solving this problem led some very smart people to develop the Efficient Market Hypothesis. EMH postulates that it is impossible to devise an algorithm that enables investors to earn returns exceeding those of the market as a whole. That is because the interactions of participants are, in effect, an algorithm that incorporates all information required to establish the “efficient” or “correct” price of a security.

In other words, it is pointless for anyone to collect data and deploy algorithms in an attempt to predict the future path of share prices, because the latter will quickly and efficiently adjust to whatever new information might come along. That said, it is worth keeping in mind that EMH simply tells us that a security is fairly priced; it does not rule out the prospect that one could expect a positive return for a stock.

Given the stakes involved—not to mention the natural human desire to solve the seemingly unsolvable—it is not surprising that there is a whole industry, collectively referred to as active fund management, devoted to the task of trying to disprove EMH.

As one might have guessed, we are in that camp; we do not accept or agree with the theory’s seemingly logical conclusions. Allowing for some differences in our team’s individual perspectives, we believe it is possible to make predictions about expected long-term equity returns that can serve as guides to whether or not securities are attractively priced. We also believe it is possible to assess the risk to these forecasts. Generally speaking, there are three questions to consider:

  • What is an attractive return to judge the expected return of a stock against?
  • What is the expected return of a stock?
  • What is an acceptable risk to that expected return?

We think the answer to the first, as we noted in “GDP: A Better Benchmark?” can be found in the growth rate of nominal gross domestic income (GDI) and the related economic measure, gross domestic product (GDP), which we believe are the most rational gauges for assessing investment performance.

First and foremost, if investors achieve a return on capital, net of expenses and taxes, in excess of these benchmarks, they will be increasing their capital at a rate that outpaces national output and income.

In fact, such a phenomenon has arguably played a key role in how many of today’s richest individuals and institutions achieved that status. It is, in part, a function of the fact that many capital assets earn returns in excess of the rate of growth in GDP, owing to the lack of competition stemming from some combination of risk aversion, regulatory constraints and barriers to entry. Amplified by ultra-low interest rates and seemingly boundless liquidity, the result has been a breathtaking concentration of wealth in relatively few hands.

To put it simply, those who had sufficient capital to begin with, because of luck, inheritance, criminal acumen, entrepreneurial genius or savings, have been afforded a rare opportunity to accumulate vast fortunes that are out of reach to even the most hard-working and thrifty of their fellow citizens.

The accumulation of wealth relative to the value of a nation’s output of goods and services, therefore, is not necessarily driven by skill, but rather by the interesting historical phenomenon: return on capital is often higher than the future growth of GDP. Eventually, of course, something has to give, and this is where revolutions and wars, natural disasters, pandemics and other mechanisms of self-correction regularly come into play.

Another reason why the well known gauges of economic activity can and should serve as the relevant investment benchmarks stems from the fact that a nation’s ability to produce goods and services likely represents the natural limit to the aggregate value of societal assets. Ultimately, the latter is determined by the output they can be converted into.

Certainly, there have been fluctuations in the relationship between output and the various types of incomes, as we noted previously. Indeed, variations in the distribution of income between rents, interest rates, wages and profits have made it possible for certain asset prices to outpace economic growth, at least for a time. Over the past decade, for instance, equity values increased dramatically as corporate profits assumed a historically large share of the national income mix.

Even so, other evidence points to a strong link between incomes and output. The empirical work of French economist and philosopher, Thomas Piketty, suggests that, over the long run, there is a relatively stable relationship between the value of GDP and society’s assets. While there may be periods when one is high relative to the other, the relationship has been remarkably stable, on average. Few of us have the patience, however, to stand pat until such variations occur, or the psyche to capitalize on opportunities when they arise. Moreover, even with the cyclical swings, the returns from most assets have over time been largely positive and the opportunity costs of waiting for just the right moment can be significant. 

So, assuming that the minimum objective for investment activities is to earn returns that exceed the pace of economic growth, the critical question is: How do we calculate the expected return for any particular asset? The answer can be seen as simple or complicated, depending on one’s focus and perspective. In the case of a stock, for example, the expected return is typically calculated as the sum of the dividends that will be paid plus the change in the value of the security over time, expressed as an annual percentage rate. 

Quantifying the expected return from dividends is relatively straightforward. Historic dividend payments are known; future payments, of course, are not. Nevertheless, history suggests that established businesses seek to maintain or increase their dividends, subject to limits imposed by earnings, free cash flow and balance sheet requirements. If one is uncertain about how to forecast future dividends, then current distributions can be used as a proxy. Dividing the annual payout by the current share price equals the dividend yield.

The other component of expected return is derived from the growth rate of the stock’s “terminal value”—that is, its market price. To estimate this variable, one approach is to view it from the vantage point of expected long-term economic growth. Generally speaking, the growth rate of earnings for all businesses in an economy will match that of nominal GDP. While there can be periods, as noted above, where that might not be the case, economic growth has tended to be somewhat—and, perhaps, amazingly—stable over time, which suggests this measure is a good starting point for defining the baseline standard. 

Looked at another way, if a company’s profit is expanding at a faster pace than the overall economy, it means the business is either taking share from competitors, supplying an expanding market, paying less for labor and other production factors than competitors, or extracting a premium price for its products and services. History suggests that such a company will realize an above-average increase in its terminal value, and vice versa.

The challenge, of course, is to determine how fast earnings are and will be growing. If one assumes a dividend yield of, say, 2%, a company would need a 6% earnings growth rate for its stock to have an expected return of 8%, matching both the long-term annual return from equities and the objective of garnering a return above the pace of economic growth, net of expenses and taxes (Note that only the dividend received is taxable while any tax due on the cumulative increase in a stock’s terminal value is deferred until a sale is made).

The critical issue, then, is to evaluate whether it is reasonable to assume that a company whose stock is being considered as a possible investment will see 6% annual growth in earnings—typically, earnings per share, or EPS. One approach is to break down and evaluate expectations for a company’s earnings in the same way as one might assess the outlook for GDP growth. Among the questions that could be asked are:

  • Will the company be able to increase prices at a rate above, below or near the rate of inflation?
  • Will it be able to expand its sales at a rate above, below or near the pace of population growth?
  • Will it be able to reduce its costs at a rate above, below or equal to productivity growth?

There are other considerations, including the amount of capital a company needs to grow it existing business. If the total equals the earnings it retains after paying dividends, the calculation is fairly straightforward: expected return equals the dividend yield plus anticipated nominal growth in earnings.

However, if the business generates more capital than necessary, the excess should be factored in. For example, with an expected dividend yield of 2%, an expected earnings growth rate of 6%, and excess capital of 2%, the expected return is 10%.  The assumption here is that the excess capital is invested at a rate that is at least equal to the existing rate of return on capital. In contrast, if the firm is expected to require additional capital to achieve a presumed level of growth, the expected return would need to be adjusted downward. 

There is little doubt that the generation and profitable deployment of excess capital can have a potentially significant impact on returns. If, for example, a company has an earnings yield of 8%, pays out 2% in dividends, reinvests 4% in existing businesses to keep growth on an even keel, and then reinvests the remaining 2% in new businesses that can generate returns and growth commensurate with established operations, that would likely signify an attractive investment opportunity.

In reality, many companies have not been careful stewards of capital. They have squandered vast sums on unsuccessful acquisitions and misguided investment projects. For this reason, it might be necessary to adjust expectations downward if there is a decent risk that those in charge might lead a firm on a similarly destructive course.

Whether a company distributes excess capital in the form of dividends or share buybacks, or by way of investments that presumably generate returns at least in line with current levels, all have different risks and tax implications in regard to forecasting expected returns. Under the circumstances, it is also necessary to anticipate whether the company’s management and board of directors will (or will continue to) act in shareholders’ best interests.

It is worth bearing in mind that any predictions about expected returns are predicated to a great extent on the supposition that the value the equity market assigns to future earnings will remain constant. While anything is possible, history suggests that this outcome is extremely unlikely. This then becomes yet another critical risk to the assessment.

Regardless, such analyses invariably leave numerous questions unanswered or lead to assessments with wide margins of error. There are simply too many variables, including the “unknown unknowns.” But this sort of approach can provide a structured way of thinking about the factors that influence prices and investor perceptions, including dividend yields, earnings growth and terminal values.

Of course, making predictions about expected earnings does not necessarily address the many risks that are inherent in such forecasts, nor does it take account of idiosyncratic factors such as investors’ willingness and ability to assume risk. Moreover, with the methodology detailed above, only company-specific issues have been considered, while the analysis itself rests on certain assumptions about the overall pace of economic activity.

In reality, there are a variety of other, more generalized risks that can impact outcomes. One such example is valuation risk. Essentially, the higher the valuation of a company is relative to its current or future earnings, the greater the risk that expected return forecasts won’t be realized.

In the approach outlined above, for instance, only the current dividend yield and expected earnings growth rate are featured as variables, and valuation is ignored. However, this is somewhat utopian. Practically speaking, the behavior of others can alter the dynamic. For a company where the expected return is estimated to be 8%, the prospect that such performance might not be realized is higher if its stock is trading at 20 times its earnings, rather than 10 times. That is because a larger multiple implies that investor expectations are high and, therefore, are subject to greater risk of disappointment.

Research undertaken by Yale University economics Professor Robert Shiller regarding the relationship between the cyclically adjusted price-earnings (P/E) ratio (CAPE) of the S&P 500 index and its future performance lends further support to the notion that the lower the current valuation of a company’s stock, the higher one’s confidence should be about expected return estimates.

There is also something of a fundamental twist to this argument. In the case of two stocks with the same 2% dividend yield, for example, logic would suggest that the company whose shares are trading at 10 times earnings is in a better position to increase its payout than the more highly valued alternative. After all, with a yield of 2% and a price-earnings ratio of 10, the former would only be distributing 20% of its earnings in the form of dividends; the latter, with a P/E ratio of 20, would be paying out 40%, or twice as much.

Finally, another category of risks that can put pad to expected return forecasts are those that fall under the broad heading of “macro.” These can range from higher taxes to natural disasters to the confiscation of private property to a collapse in economic activity stemming from geopolitical events, pandemics and large-scale policy mistakes. Because these can be difficult or even impossible to anticipate in terms of their timing and impact on any one company or sector, many investors simply choose to mitigate the risk through global and asset class diversification, the deployment of multiple investment strategies, and hedging.  

In the end, the process of trying to figure out what a security is worth can raise more questions than it does answers. But without some sort of defined process and a measure of understanding of the factors involved, the balance may prove to be heavily—and unfavorably—skewed in favor of the former.

Please see important disclosures and disclaimers:

Investing in Quality

Research suggests that higher quality stocks tend to outperform lesser quality peers over the long run. But what does “quality” actually mean in this context?

According to the Oxford Dictionaries, the word is defined as “the standard of something as measured against other things of a similar kind; the degree of excellence of something.” But as with other such descriptives, it can—and often does—mean different things to different people.

That said, there seems to be some measure of agreement about what it signifies with respect to investing. “Quality” refers to those investments that have a higher probability of meeting return objectives than randomly selected alternatives, generally with less risk than the broader universe of comparable investments. In other words, they exhibit a measure of consistency and stability that tends to garner a premium in an inherently unpredictable world.

Quality is not all that matters, of course. In fact, investments that fit this description may not be worth buying at current prices. Investing in quality stocks, for instance, only makes sense if the shares can be acquired at a cost that is attractive relative to current and expected returns and prospects.

But, first things first. In determining quality, it helps to outline the factors that have, historically at least, served to separate the wheat from the chaff. In the equity market, one differentiator has been some combination of competitive advantage and high barriers to entry. If a company has cost or pricing advantages, it will likely earn superior and steady returns on capital for extended periods of time. If it is difficult for new competitors to enter the marketplace, these advantages will likely be sustainable. While not guaranteeing a positive outcome, these attributes imply greater earnings predictability and reduced risk of negative surprises, which has a value to investors.

The notion of what constitutes a competitive advantage can be somewhat nebulous, depending on the industry involved, operating environment, and other factors. Although books such as Michael E. Porter’s Competitive Strategy: Techniques for Analyzing Industries and Competitors offer useful road maps for identification and evaluation, the assessment process can be a Herculean task, even for those, such as corporate managers, who are close to the ground. Moreover, as a qualitative endeavor, it is naturally fraught with biases and risks.

Regardless, such an exercise can pay many dividends, including providing a better sense of the fundamentals that make a company—a quality company—tick. Among the questions worth asking:

  • Are customers willing to pay a higher price for a company’s products and services than for those of a competitor?
  • Can it deliver its products or services at a lower cost than its competitors or substitute products?
  • Do customers face a high cost or risk in switching from one supplier to another?
  • How expensive or risky is it for potential competitors to enter the market?
  • How might the circumstances referred to in the aforementioned questions likely to develop in future?

Even with an accurate evaluation of the competitive landscape, it makes sense to crosscheck qualitative assessments with quantitative data to try to verify a company’s sustainable edge. The latter category can include gross and operating margins on sales, and returns on assets and capital. If margins and returns have been consistently high relative to those of other companies or industries, it bolsters the view that a business enjoys a genuine advantage.

Investors may also wish to incorporate another method for assessing a company’s situation and prospects. Developed by the Boston Consulting Group (BCG) in the 1970s, the Growth Share Matrix seeks to evaluate businesses along two dimensions. The first describes the growth rate of the overall market, which approximates to it attractiveness. The second details a firm’s market share, which is a proxy for its profitability. BCG used this matrix to segregate businesses into four quadrants, as follows:

  1. “Stars”: large market share in a high-growth market
  2. “Cash Cows”: large market share in a low-growth market
  3. “Dogs”: small market share in a low-growth market
  4. “Question Marks”: small market share in a high-growth market

Not surprisingly, those who seek higher quality investments tend to favor businesses that fall into the first two categories.
It is one thing to have a competitive edge, but it is just as important to be able to sustain that edge. For a quality company, that means a strong balance sheet and positive cash flow, which enables the firm to meet most contingencies. Being faced with the prospect of having to exit profitable niches or markets due to temporary downturns or disruptions is not the hallmark of a well-run business.

To be sure, it’s not just cash-flow adequacy and an ability to handle regular obligations that matter. Historically, one thing that has made a company attractive to its customers—and, consequently, a quality investment—is the perception of financial strength. If customers need a product or a service, particularly components that are critical for their businesses, they would naturally prefer to deal with suppliers that have the wherewithal to provide ongoing support, even amid the worst of downturns.

This capability can be assessed in various ways. One approach, though not necessarily the best given the failures that became evident during the global financial crisis, is to ascertain the credit ratings assigned to the company by agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. Although their scales vary slightly, a grade equivalent to “A” or higher would likely mark the minimum threshold for a quality business.

Another, probably more reassuring method is to go directly to the financial statements. Among the questions to ask:

  • Does the balance sheet reveal a significant level of cash relative to current liabilities and the cost of running the business, especially in comparison to rivals and others in the sector?
  • Is the amount of debt outstanding small relative to balance sheet equity and free cash flow?
  • Is balance sheet equity appropriate in comparison to market capitalization?
  • Has historic operating cash flow consistently covered capital expenditures and financial obligations, and left room for consistent dividend increases and share repurchases?
  • Have revenues been expanding consistently, ideally at a pace higher than corresponding increases in nominal growth in the overall economy, without excessive volatility?

Potential trouble spots shouldn’t be ignored, of course. Established companies whose capital expenditures continually outpace depreciation expenses may be losing out to competitors or, perhaps, are simply in bad businesses. Firms that consistently increase debt relative to equity may have unsustainable operating models or are relying on aggressive financial engineering. Either way, they are unlikely to fall under the moniker of “quality.”

One thing that matters as much as—or perhaps more than—numbers, of course, is people. As with an evaluation of the competitive landscape, determining whether a company has the right kind of management can be a highly qualitative exercise—no pun intended—with severe limitations. Still, the executive suites of well-run businesses do seem to have certain things in common, including:

  • Experienced leadership, long tenures, a deep bench, and an orderly succession plan
  • Long organizational history
  • Clear sense of objectives and strategy
  • Willingness to push the business and its industry into the future

Not all of the criteria are subjective. Arguably, capital allocation is one of the most important functions that senior management is responsible for, and this can be measured. Performance can be judged by looking at returns on assets, equity and capital over time. Consistently high results are positive; high and improving returns are better.

In fact, if management has been able to invest retained earnings and achieve consistent or improving returns on assets, capital and equity, the firm is effectively firing on all cylinders. In other words, if it can expand its business using annual earnings and realize the same or higher return on that investment—at a time when the market is valuing the business at more than book value—that is a great deal for shareholders. The company makes a dollar, management invests it, and that dollar is immediately worth some multiple of that in market value.

It goes without saying that the management of a quality company should be oriented towards maximizing the long-term value of being a shareholder. If management is unable to invest profits at attractive rates of return, it should be able to articulate and implement a clear strategy for returning excess capital to its owners in the form of dividends or, perhaps, share buybacks.

However it is accomplished, an assessment of management strengths and weaknesses is a critical step in identifying a quality investment. Management drives the strategy of a business; they drive the implementation of that strategy; they drive capital allocation; and they drive returns to shareholders. It is hard to imagine a long-term success story without the right characters in charge.

Finally, another attribute that helps to define a quality business comes down to how it is perceived in the marketplace—by investors, employees, customers, suppliers and other stakeholders, including the community at large. More specifically, it should have trusted products and services and a highly regarded brand.

Once again, evaluating such perceptions can be a highly subjective process. However, it is possible to view relevant qualitative data in a more quantitative light. There are any number of surveys, for example, where investors and employees rank companies based on attributes such as trust and quality. Although the rankings in such surveys are probably not that material, the questions of whether a firm is on the list or not, and whether it is near the top or bottom, reveal a great deal. With few exceptions, perceptions about a firm, whether positive or negative, tend to be durable and difficult to destroy.

If the answers to these various questions about a company’s operating environment, financial condition, management and other factors describe a quality enterprise, it suggests that the downside risk, in relative terms at least, is limited. But that does not really address the question of upside. One could argue, of course, that if everyone knows a good thing when they see it, that faith will be reflected in its price. With that in mind, the biggest risk would seem to be in acquiring the investment at the wrong price.

That said, quality stocks have proved to be a good investment even for investors who are impatient or unwilling to wait for an optimal moment to buy—say, after a broad market decline or following an adverse swing in short-term sentiment. That is because quality companies have historically provided an extra cushion to shareholders in the form of increasing dividends or buybacks.

Acquiring the stock of a quality company, even at what many might view as the right price, is not the end of it. As with investing generally, the metrics used to initiate an investment should also be evaluated on a regular basis to determine whether the original thesis remains intact, while taking care to avoid confirmation and other biases. The benefit to this approach is that it provides the confidence necessary to stay the course and augment the exposure when opportunities present themselves. If the investment case is no longer valid, history suggests that investors in quality companies will have some time to formulate an exit plan.

In the end, of course, the future is unknowable and unpredictable, and no investment approach is infallible, including one oriented towards investing in quality. However, to reduce the risk of owning investments that will perform poorly, it seems to make sense to target those businesses with qualities that have traditionally worked for the benefit of shareholders.

Please see important disclosures and disclaimers:

GDP: A Better Benchmark?

Investors and portfolio managers with an absolute return objective typically rely on market or yield-derived benchmarks when evaluating investment performance. But is this the best approach?

Two of the most commonly used measures for assessing performance are volatility-adjusted returns relative to indexes such as the S&P 500 or benchmarks centered on the absolute returns realized by certain subgroups of investors. Arguably, such comparisons may be illogical given the implicit promise of “absolute return.” In both cases, performance evaluation and, therefore, portfolio allocation and securities selection preferences may be unduly influenced by random noise, structural inefficiencies, reputational biases, and other vagaries of the financial world. Short-term considerations end up muddying long-term perspectives.

In contrast, a benchmark based on overall economic activity may be more suitable and confer significant advantages for investors. Such a gauge helps define what returns are attractive relative to societal wealth creation and, importantly, which are economically feasible. It also helps to set realistic expectations that can reduce the temptation and, in some cases, the compulsion to chase potentially overvalued investments that are appreciating in price, thus alleviating certain of the risks associated with near-term volatility. An economically-derived yardstick should also encourage investors to weigh the merits of an investment relative to the outlook for demographic, productivity and inflation trends, as well as expectations regarding the relationship of investment income to wages and other earned income.

One key assumption, of course, is that asset values, as represented by equities, fixed-income and other classes, are intrinsically tied to a society’s productive capacity. While it is virtually inevitable that one or more companies, subsectors or industries will perform better (or worse) than the overall economy for some period of time, it is not feasible that most or all businesses will do so, especially over the longer term. Specifically, if one accepts that a nation’s ability to generate income and increase wealth is a function of its output of goods and services, it would be difficult, if not impossible, to argue that corporate America can garner a larger share than what is available.

With this in mind, it would seem that the most relevant benchmark for U.S. investors to use when evaluating investment performance is the well known yardstick of productive capacity, gross domestic product, or GDP.  Some might argue that gross domestic income, or GDI, which represents the sum total of income, profits, rent and interest being generated in the economy, is more appropriate, but the reality is that GDP and GDI are, for practical purposes, the same thing. While GDP measures the value of the output of goods and services, GDI measures the income derived from this production. For every sale—that is, GDP—there is a corresponding amount of income—GDI.

To be sure, the composition of national income needs to be understood. If the relative proportions of income, profits, rents and interest remain fixed, then the return potential for capital and savings—profits and interest—will, in fact, be the same as the nominal growth rate of GDP. However, history suggests that the relationship is not constant. Therefore, the potential for relative shifts between the four components could prove to be a critical consideration for investors. But factoring in such changes would be no different than accounting for variations in other important drivers, including labor productivity.

Regardless, with an economically-derived yardstick, U.S.-based investors could establish realistic and potentially achievable investment objectives. The long-term goal would be to generate returns after taxes and fees that exceeded the average annual compound growth rate of nominal GDP. If returns outpaced that target, investors would be doing better than the U.S. overall and their financial wealth would be growing at a rate in excess of increases in aggregate income. Such a gauge would provide a simple and uniform means for evaluating different opportunities and for forecasting average returns.

One objection to using such a yardstick is that a number of companies, especially the blue chip multinationals that comprise a significant share of U.S. stock market capitalization, have operations that span the globe and hence, are less tied to U.S. growth prospects than, say, smaller or domestically-focused firms. Indeed, foreign sales are thought to account for a third or more of S&P 500 company revenues. Nonetheless, the U.S. represents more than 20% of global GDP, and while some might argue otherwise, the maxim, “When America sneezes, the world catches a cold,” still seems as relevant as ever.

Others might wonder about the consequences of rising (or falling) price levels. There’s little doubt that inflation-adjusted growth is what matters to most people, whether they are workers, managers or policymakers, but it can be difficult to isolate or disentangle the inflationary components of nominal output data, especially insofar as the broad economy is concerned. It is not uncommon, for example, to see rises in inflationary expectations spurring an increased pace of consumer spending or business investment, and vice versa. At the company level, there is often no clear sense of which aspect of input or output prices represents the inflationary component. All of this argues for the simplicity of a nominally-oriented measure.

Finally, and most importantly to some, such a benchmark does not really take the notion of risk into account. Indeed, it’s a universal truth that investors, like everyone else, must balance risks versus rewards when making decisions about the future. Even so, it could be argued that risk tolerance is largely a matter of individual preferences and circumstances, as well as a function of the chosen investment horizon. Investors may decide, for example, that standard barometers of risk are inconsistent with a genuine long-term perspective. Although it is common practice to use the same gauge for assessing performance as for evaluating risk, that may not be the only or best approach.

Assuming that an economically-derived benchmark is appropriate, what should investors be expecting in terms of future returns? Over the past 10 and 20-year periods, for instance, the average annual pace of U.S. nominal GDP growth has been 3.6% and 4.5%, with inflation running at two and 1.9 percentage points, respectively. Since the data series began in 1929, nominal growth has averaged 6.4%, with inflation equaling 2.9 percentage points. Although there are no guarantees that the future will mirror the past, it is not unreasonable to assume that nominal GDP growth will be in the range of 4.5% to 6.5% over the longer term. Such an outlook would be consistent with annual population growth of just under 1%, annual productivity increases of 1.5% to 2.5%, and inflation rates of 2% to 3%, suggesting net after-tax expected returns of 5.5%.

That said, it wouldn’t be surprising to see growth rates for certain developing countries and regions, measured in local currency terms, prove to be marginally better than that of the U.S. and other mature economies, aided in part by greater productivity gains and a more liberal tolerance for rising prices. Even so, that shouldn’t take away from the fact that when it comes to thinking about the future, investors might find that anchoring expectations around an economically-derived benchmark is the better approach.

Please see important disclosures and disclaimers: