One Big Company: Why We Like The 3% Rule
Charlie Munger is famous for saying “Invert, always invert”. Time to do a little inverting! Today we’re going to perform a little thought exercise about a really common investment. I won’t tell you the name of this investment until the end of the article. As we go through this thought exercise, try to guess what company it is. Do you think it’s a good investment? Will it help us gain financial independence, or send us back to wage slavery? Let’s find out!
The Business
The business we’re going to look at today is a really large business, founded in 1957. It has a significant chunk of global GDP. Its products and services span the complete gamut from consumer products to finance, and energy. Practically any industry you can think of, this company is involved somewhere.
That’s not to say that this company is a static behemoth. It keeps up with the times, and trades new companies in (and out) of its portfolio frequently. This has allowed our company to grow profitability over its 59 years. New investment decisions are handled by a investment committee that looks at a variety of factors before deciding to acquire a new company.
This company is also a global enterprise, and does business in nearly every country in the world.
Dividends
Our mystery company pays a dividend of about 2.18% yearly. Before Mr. Market got crazy, dividend yields use to average around 4% – which would have been very healthy for an early retiree. Alas, this is no longer the case. Anyone hoping to invest now will only get the paltry 2% dividend.
Dividends have been growing on average at about 5% annually. For the 2.18% dividend yield to grow significantly (say to 4%), it would take roughly 13 years.
That 2.18% dividend yield is 44% of corporate earnings, which means 55% of earnings are available for growth, share repurchases, and other corporate needs (anybody need a private jet?).
Growth
Usually, when you encounter a high PE ratio, you expect to see fast earnings growth. Unfortunately that’s not the case here, our company is a slow grower. It has been growing sales at a rate of 2-3% for the last few years (adjusting for inflation).
How can dividend growth be faster than sales growth? Mainly, via share repurchases. Economies of scale may also be a contributing factor.
With sales growth like that, you’d expect to see the stock in the gutter, but EPS growth has actually been reasonable (due to stock repurchases). If the company ever stopped purchasing shares, EPS growth would probably fall to these 2-3% growth levels. That would be a very sad day for investors, but economies of scale can only get you so far…eventually the law of large numbers comes into play.
The law of large numbers at work – Once a company gets to a certain size, it becomes really hard to grow quickly (or even faster than GDP). How has our little enigma grown compared to U.S. GDP?
This slow sales growth is (I think) set to continue for quite some time, due to slow global GDP growth rates. Investors better hope those share repurchases work out!
Valuation Metrics
Like most large companies, our mystery company is traded on the public markets. As I write this, the company has a PE ratio of 21.95. That’s pretty high. In the past, the company used to trade at an average PE of 15. Mr. Market has been very optimistic lately.
As the share price has been bid up over the years, share repurchases have become less effective (high share repurchase price = lower ROI).
Earnings yield (the PE inverted), is a mere 4.5%. For those hoping to live on the 4% Safe Withdrawal Rate (SWR) for the next 50 years, that’s frighteningly close to 4%.
The mystery company also has a price to book value of 2.67. Definitely not cigar-butt style investing here. This kind of metric defines a premium priced company.
What Company Is It?
So what company are we talking about? Well it’s not exactly a company at all. Instead, it’s a rather large collection of 500 companies. If you haven’t guessed already, I’m talking about the S&P 500 index. Much of the data presented here was collected from www.multipl.com (Great site, btw).
Essentially when you buy into a S&P index fund, this is the ‘company’ you’re buying….for better or worse. Low growth rates, high PE ratios, and moderate dividend growth. The S&P500 is like a giant global conglomerate. This ‘company’ is only as stable as the economy, and also experiences regular declines when the economy goes into recession.
Critical Thinking
Most common personal finance advice says to invest in a stock index fund (frequently the S&P500), and leave it alone. It’s often said that, “You’ll do fine if you follow this strategy”. Maybe, or maybe not…
That same good advice is actually making success less likely. As everyone (and their grandma) sends those billions of dollars to 500 companies; it pushes up stock prices into nose-bleed territory. Yields get pushed down to very small numbers. Meanwhile, to maintain dividend growth, S&P 500 companies are almost required to keep purchasing shares.
Dollars invested in the S&P 500 today will earn 4.5%. I’m using simple earnings yield here, but some experts believe using Shiller PE 10 data for the earnings yield is even more predictive (Schiller PE 10 earnings yield in this case is only 4%).
Those people hoping to see 7% from the S&P 500 are placing their hopes on economic growth. The only problem is, economic growth has been terrible lately.
As you may already know dear reader, the frequently cited 4% rule came from the Trinity study. When the Trinity study was originally conducted, researchers looked at “successful retirements” in both stock and bond investments. When reading the study (and I recommend you do), two things should smack you upside the head (like a wet tentacle):
1. Only 30 years: The Trinity study only looked at success during 30 year periods. Most financially independent early retirees have much longer time horizons – maybe 50 or 60 years.
2. Slower Growth: Data used for the study (1925 to 1995) was during periods of higher GDP growth. This would have the effect of producing higher returns for portfolios in the Trinity Study.
If we consider the need for longer retirement time horizons and tiny GDP growth (in our modern times), doesn’t it make sense to be more conservative than the 4% rule might suggest? I think it does.
Given the S&P 500 earnings yield, the Trinity’s 4% rule will just barely work (today). Any significant economic blip could cause problems for a early retiree’s portfolio…Especially during the early years where spending is closest to the 4% SWR. If that economic blip goes on for an extended time period, financial independence failure could happen.
Mr. Tako’s Perspective
In my posts here at Mr. Tako Escapes, I always mention my 3% rule. It’s more conservative than 4%, but also more likely to work given today’s reality: Low real GDP growth and very low earnings yield.
How does 3% hold up in past periods? When I run retirement simulations using cFireSim or fireCalc, I see 100% success rates when using 3%. By comparison, failures at 4% happen about 20% of the time.
I’m personally sticking to my 3% rule. In today’s environment, 4% is just too close for comfort.
What do you think? Is the 4% SWR your go-to withdrawal rate?
[Image Credit: Flickr]
Thx for this new perspective in the 4pct rule. As FIREmen, we have indeed a longer horizon than 30 year.
In my target allocation, I plan to have more than one source of income. In an ideal situation, I have a rental that covers already 30-35 pct or so of our needs. A second source would be a DGI portfolio. Here, the actual yield is less important, it is the start dividend and the growth of the dividend that matters. The last part would then be an index portfolio. Here, until today, I thought it would be 4pct
For me, part of a good retirement portfolio is also a diversification across different investment styles.
Nice post. We were actually waiting for someone to post an article about this topic, so we could get some additional perspectives on the matter. We think you are correct and that growth will slow over the coming decades as a result of many different reasons. It is probably wise to assume a lower growth rate if you want a secure financial retirement (early or not).
This was one of the reasons for us to add a (physical: actual buildings) real estate component to our portfolio (see also AT above, whom appears to be on the same page).
However, you could add more mid and small caps to your portfolio too. These generally have a higher growth rate, but also high risk. Not sure about bonds at the moment, they may be a good stable income, but rates are pretty poor too, right now with little relieve in sight due to many central banks dropping rates to zero or below.
A well-diversified portfolio really is key, but what that should entail is pretty much a very personal preference.
Great post and nice perspective!
I think 3% is a good idea while you’re young. You can supplement the 3% by working part time and side hustling. Once we get to 55, I would be much more comfortable with 4%.
Interesting idea Joe. I guess it depends upon how the first decade goes. Although, I highly doubt the U.S. will see decades of 3%+ growth again; Immigration isn’t nearly as large now, and people don’t have babies like they used to.
Hmmm I have considered switching my 401k over to Ex US funds, but most countries Ex US seem like terrible investments right now. With that said all my non 401k funds are in individual stocks that have a PE closer to 10…and hopefully a much higher future growth rate than the US overall.
I think every single day about the 4% rule. While I agree that growth will be slower, I’m still not super concerned for a couple reasons:
1) The 4% rule assumes no future income. I already have a very significant source of income lined up in the form of social security. I’m guessing that most first world countries have similar programs.
2) The 4% rule assumed an expense ratio of something like .76%. If you move your stuff to low fee index funds, you’re probably paying under .25%. That half percent makes a huge difference! In my case, my goal is $1,000,000, so I’d withdraw $40,000 during my first year. That half percent comes out to an additional $5,000, bringing me down to a 3.5% rate.
Never forget that 4% is the floor too. In many years, you could have gone much, much higher. Check this out: http://im.mstar.com/im/newhomepage/151228_cow.png
With all of that said, I’m not thrilled to be retiring into an environment with these sky-high valuations. If I were to quit today, I’d be playing it very conservative for at least the first 5 years.
I’ll agree with you there, play it safe at least the first 5-10 years. If things pick up again, 4% may work out.
I’d rather err on the side of having too much money than not enough.
Take San, you are wise but way too conservative. As You know there is a massive 33% difference between 3% and 4%. Even in 95% of the cases, the 4% was resulting in a strong positive balance and in close to 85-90% of cases, it resulted in a higher value ending portfolio. So, I think 3% is extremely conservative unless you plan to leave a very large estate. Due to the way the long tail works, once you cross 40-45 years there isn’t much difference between perpetuity and this time frame. 3.5% WR is essentially good for a 50 year to perpetuity retirement horizon. There is a nice analytical article on Go curry cracker website on this, I don’t have the link handy. I think you can safely go to 3.5% SWR and enjoy the 15% increase in spending this provides over the 3%. That’s huge in my book.
Yes, I’m aware of the success numbers for 4%. Given today’s environment, which has no historical precedent in the data, I think I’m overly optimistic!
But yes, technically at 3.5% I still see good success rates…3% is just a nice round number to write about. 🙂
Michael Kitces of Nerd’s Eye View says the Trinity study fully accounts for this low return environment, and someone who retired in 2000 is managing to get by with the 4% rule. (Assuming the traditional 30 year retirement.)
It doesn’t. Look at the data yourself.
To add to my previous comment, the market earnings yield of 4.5% cannot be viewed in isolation but should be compared against the prevailing interest rate environment. If we remain in a decade of near zero-interest rates, the current equity risk premium of 4-4.5% is not that far from a period of higher interest rates that also had similar equity risk premiums. Take Japan and Europe with near negative interest rates, even a 25 PE ratio may not be unreasonable there because it’s the risk premium conveyed by the earnings yield that’s more important than absolute earnings yield alone in my view. After all, stocks are not an insulated asset class; they exist in a supply-demand equilibrium among other capital asset classes. If treasury yields rise towards 3% and more, then there will be inevitable compression of PE ratios to achieve a similar equity risk premium spread.
That’s a good way to think about it…although earnings yield is not without it’s own issues.
I think it’s highly unlikely we see treasury yields at 3%…as you said we can’t view things in isolation. In a world of negative rates, if the tide begins to rise, capital will flow to that ‘bay’, forcing down yields.
One other observation from your article I found interesting. The S&P index is delivering 2.18% yield plus expected 5% annual dividend growth as you write. With similar or even lower beta than the index, it’s possible to assemble a portfolio of quality dividend growth stocks that deliver the same 5% dividend growth but a starting yield of 3.5-4%. That’s a big boost to current income while keeping growth prospects intact and at same or lower volatility than market. Way to escape the wage slavery faster as another great post by yours says.
Third comment…Boy, I must love this article!
Indeed, I have pretty much done that exact thing with my own portfolio! Crafting a portfolio with similar growth prospects but with a higher starting yield is easy enough! Generally, I look for a starting yield of at least 3% and earnings/dividend growth of at least 5%. As you can guess, my “risk-free” rate is around 8%…
Mr. Tako,
First time visitor to this site and I like it a lot.
How do you think inflation would affect the 3 or 4% number? It’s also at record lows…
Low inflation and low investment returns are correlated. Whether one causes the other, it’s unclear. Kindof a chicken or the egg problem. I’ll let economists debate the reasons for it, but where you have low inflation, real investment returns are lower.
Basically, one more reason why I don’t expect big returns in the near-term.