The ROE Conundrum: Where Did The Shareholder Returns Go?

Personal finance can (at times) be a difficult and deliberately obtuse field for a layman to study.  With acronyms like ROE, EBITDA, ROIC, CAGR, PEG, and hundreds of different valuation ratios, investing can be a dizzyingly complex topic.

Like other fields of great complexity, humans have created helpful little maxims to help wrap our terrestrial brains around the complex financial topics of personal finance and investing.

Maxims like:

“A penny saved is a penny earned.”

“Don’t put all your eggs into one basket.”

“It’s time in the market, not market timing that matters.”

“Don’t cut the flowers and water the weeds.”

“A bird in the hand is worth two in the bush.”

“In the short term the market is a voting machine, in the long-term it’s a weighing machine.”

and finally…

“Over a long enough holding period, stock returns should approach the returns of the business.”

It’s this last maxim that’s going to be the focus of today’s blog post.  As a buy and hold type investor, I often espouse the long-term holding of shares as being an “owner of the business” and not a trader of shares.

On the surface, this maxim seems to make perfect sense — Given a long enough holding period, any errors in buy price or year-to-year changes in market premiums (often discussed as the PE premium) should cease to matter, and the long-term ability of the business to compound returns on shareholder equity (ROE) should matter the most.

To put this another way, over a long enough time period it’s supposed to be the business that will generate your returns, not your ability to time the market or pick a “fashionable” stock.

It’s with this idea in mind that I’ve often wondered why stock returns often lag the business returns over long holding periods. — Even in indexes like the S&P 500, stock returns have seriously lagged behind the ROE of it’s component businesses!

Why is that?

A Strange Conundrum

It’s true — Over a 30 year holding period (1990 to 2020), the S&P 500 has earned 7.8% (10.1% with dividends reinvested).  Yet at the same time, the return on equity (ROE) of the S&P 500 has averaged a healthy 16% in recent years.  (Year to year this can vary wildly of course.)

16% is obviously WAY more than 7.8%!!  Where did the missing 40% of the S&P 500’s return go?  Shouldn’t shareholders actually be earning closer to 16% instead of 7.8%?

There’s several ways to look at this problem, but the best way to start is to pick the lowest-hanging fruit on the tree of missing shareholder return — The obvious culprits first!

Culprit 1: Dividends

If you think of the compounding of money in a simple bank account, any interest that is reinvested gets compounded.  Any interest that is spent WILL NOT get reinvested (and thusly won’t compound).

Simple enough, right?

If we extend this concept to stocks, any earnings that the company reinvests back in the business will be compounded (what I call internal compounding).  And, any earnings paid out to shareholders in the form of dividends WILL NOT be compounded.  (Duh!)

Dividends certainly aren’t a bad thing, but cash payouts from the stock are not going to compound value for the shareholder.  (Unless of course the shareholder decides to re-invest those dividends, a process I call external compounding)

During our hypothetical 30-year period, the S&P 500 paid-out anywhere from 29% to 190% of it’s earnings as dividends to shareholders.  (That large 190% payout occurred during the 2008 Great Recession when earnings quickly plummeted near the end of 2008, but the dividend cuts actually happened in 2009)

If we ignore those extreme data points, the S&P500 normally pays-out somewhere between 30-40% of it’s annual earnings as dividends.  Assuming the remaining earnings will be reinvested back into the business at similar rates of return, a good 60-70% of the ‘E’ portion of ROE should be compounded every year.  You can think of this as a 9.6%-11.2% compounded annual return from what remains after dividends.

That means a big chunk of our annual return is distributed as dividends, but not all of it.  We’re still a long ways off from that return of 7.8%.

This means there must be more culprits to look at!

Culprit 2: Bad Share Buybacks

It’s estimated that S&P 500 companies spent 371 billion on share buybacks in 2020, and that’s actually down 50% from 2019.  It’s safe to say that A LOT of money is spent on share buybacks.

But are these buybacks effective at compounding shareholder value?  It stands to reason that at least some of the time that money is going to be ineffective (wasted).

How does this happen, you ask?

As you might be aware, corporate executives are often awarded large numbers of stock options and shares as part of their annual compensation.  These amounts are significant and can dilute shareholders because of the huge number of shares or options issued to executives.

The highest executive award I’ve ever seen, was a CEO stock award that was literally 10% of the company’s market cap in a single year.  Outrageous!

In order to keep this dilution from reducing earnings per share, the company has to buy back TONs of stock just to keep the share counts similar to prior years.  This is what I consider a bad share buyback.  It literally does nothing for shareholders — no compounding of value is occurring.  It’s just maintaining the status-quo.

This kind of buyback can be thought of as merely executive compensation.

According to economists Ed Yardini and Joe Abbott in their recent book Stock Buybacks: The True Story, buybacks used to offset dilution accounted for 2/3 of all stock repurchases.

There’s also the case where share buybacks can be ineffective when done at too high prices.  After all, the price you pay for a business really does matter — even if it’s your own business that your buying shares of.

Unfortunately S&P 500 companies tend to spend more on buybacks when share prices are high instead of when share prices are low… exactly the opposite of what a good investor would do.  They’re buying when the price is high, and not buying when the price is low.  This seriously reduces buyback effectiveness.

Don’t get me wrong, at low prices (at or below book value), a share buyback can add significant value for shareholders.  Unfortunately, most S&P 500 companies trade at high multiples to book value.  It’s not unusual to find companies trading at 4 or 5 times book value, and tech companies often trade at even higher multiples.

Simply put, high stock prices make the hurdle for a good share buyback that much harder to meet.

So how common are these bad share buybacks?  According to one study by Fortuna Advisors, 64% of the companies in the S&P500 had negative effectiveness.

Ouch!  Depending upon the year, this culprit could easily eat up 3-4% of a shareholder’s return using some back-of-the-napkin math!

At this point, we’re getting much closer to understanding where all that shareholder return is disappearing to, but there still might be one culprit left…

Culprit 3: Bogus Earnings Numbers

If you’ve ever studied business accounting, you may be aware that the so-called ‘earnings’ of a business are something of a fictional story that accountants like to tell.  As in, “Wow your earnings numbers look great, but how much did you really make last year?”

There’s a myriad of ways that accounting earnings can be adjusted, (and I certainly don’t have time to cover them all here) but it’s important to note that the cash generated by a business can be a significantly different number than the stated “earnings” found on the income statement.

One of the biggest areas where earnings can be understated, is in the area of depreciation.  Deprecation is the wear and tear on buildings, machinery, computers, and all other physical goods needed to run a business.  Usually these items follow a depreciation schedule over a set number of years.

The problem is, over time the cost of the thing will change significantly due to inflation and other market forces.  The cost to replace that item after it is fully depreciated maybe not be anywhere near the original purchase price!

To give an example: Imagine a company purchased a machine which they intended to depreciated over 15 years.  Let’s say they paid $10,000 for the machine.  Over those 15 years, the cost of the machine would be depreciated each year on the earnings as an expense.  Over 15 years the cost of that machine would be fully depreciated, but when came time to replace the machine, it might then cost $30,000 or $40,000 to replace.  This happens mostly due to inflation.

The company has to spend significantly more than what was depreciated, just to maintain the business.

This means that over that 15 year time period, business earnings were actually somewhat “overstated”, and did not reflect the true value of earnings that will be compounded.  This is called “The Overstated Earnings Hypothesis”, and you can read more about it in the white paper “The Earnings Mirage: Why Corporate Profits are Overstated and What It
Means for Investors“.  (Note: It’s a long read)

This depreciation example is extremely common in the S&P 500.  You’ll find that many S&P 500 companies will depreciate at one rate, but need to spend significantly more than that just to maintain the same level business.  (Note: We’re talking about maintenance capex only here).

According to the research paper I cited earlier, S&P 500 earnings could easily be overstated by as much as 20%.  Using the same back-of-the-napkin-math, overstated earnings could account for another 3% of our ‘missing’ shareholder return.

Final Thoughts

Today I hope I’ve helped clear up one of the more important mysteries of index investing, by presenting three of the major ‘culprits’ that contribute to ‘missing’ shareholder returns.  Each of the ‘culprits’ I’ve presented here are responsible to some degree, but the amounts will definitely vary from year to year and under different economic conditions.

For example, dividends and share buybacks might not be a big factor during recession years, because dividends and share buybacks are usually reduced during recessions.  Any capital that is retained during the recession may boost shareholder returns during the following recovery years.  Similarly, during periods of very low inflation, overstated corporate earnings may not be a problem, but when inflation increases it may significantly slow shareholder returns!

The factors that could be reducing returns are variable and might not always be prevalent.  It just depends!

There may also be smaller ‘culprits’ for missing shareholder return that I’ve missed here.  In which case, please let me know in the comments what I might have missed!

While there’s very little us small investors in the S&P 500 can do about each of these ‘culprits’, it’s important to understand how all the components of shareholder return contribute to compounding your hard-earned dollars.  Each of them plays an important part in the process of compounding!

That’s it for today!  Good luck everybody!

[Imaged Credit: Flickr1, Flickr2]