The chart below shows the rolling 10-year total real return achieved by the S&P 500 index over the last 110 years. Analysts at Morgan Stanley have then ‘decomposed’ that into the three constituents of equity return – dividend yield, earnings growth and the change in multiple.
Source: Morgan Stanley as at 14/08/12
Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.
The first point from the chart is an obvious one but often forgotten: that dividends always make a positive contributor to equity returns. As you can see, over the long run, dividend yield has been a consistent contributor of between three and five percentage points of the total real return from equities, which is obviously a considerable amount of the total.
For its part, earnings growth is very rarely a detractor from performance on a rolling 10-year basis with there only having been a couple of instances over the last 110 years where this has happened. Generally profit growth tends to work in investors’ favour over the long-term and so that adds more or less the rest of your average real equity return.
By far the most volatile component of equity returns, however, and indeed what is responsible for the bulk of their bad – and, to be fair, their very good – performances is the change in multiple. That, essentially, boils down to valuation and, since the other two components of equity investing tend to work for you, the trick is to get that last part in your favour too. The way to do so, regular visitors to The Value Perspective will not be surprised to learn, is to avoid expensive investments and buy good businesses on low valuations.