“If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it…….The more symbols they could work into their writing the more they were revered……If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics may be dangerous and lead you down pathways that are better left untrod.”
- Warren Buffett
In the fall of 2015, Jack Bogle and Michael Nolan published an article[1] which discussed how Sir William Occam’s Law of Parsimony could be utilized to create a model that could estimate reasonable expectations for capital market returns. The model was, indeed, quite simple. In the article, Bogle and Nolan described it as thus:
Projected Return = Starting Dividend Yield + Earnings Growth Rate + % Change in PE Ratio
Bogle labeled each of these factors as dividend return, investment return, and speculative return. He labeled the first two as “investment” returns and the last as “speculative” returns.
Dividend Return: is the one inarguable factor in the model. For instance, today’s (July 26, 2024) S&P 500 yields are 1.32%, considerably below the 50-year average of 2.8%.
Earnings Return: It is impossible to say what market (or your portfolio’s) earnings will be five to ten years from now. For instance, the S&P 500’s earnings per share grew an inflation-adjusted 2.4% a year in the 1970s, fell 0.7% in the 1980s, grew 4.7% in the 1990s, contracted 1.9% in the 2000s and dramatically increased by 8.7% in the 2010s. Some feel it is best to use the 50-year average, while others add or subtract by where they think we are in the economic cycle. It’s up to each investor to derive the number they believe best represents the future of earnings.
Of course, earnings can’t be measured without factoring in inflation. One of the more sound ways we’ve seen of calculating this is the difference in yield between 10-year Treasury notes and 10-year inflation-indexed Treasurys. As of today, this would show an estimated future inflation rate of -1.6%. By adding the dividend rate plus the earnings growth rate and subtracting the inflation rate, an investor gets the estimated “investment” return of the markets or their portfolio.
P/E Ratio Change: The change in P/E ratios reflects how much investors are willing to pay for stocks. Higher P/E ratios suggest that investors are willing to pay more for future growth while decreasing P/E ratios reflect that investors will pay less for growth. This is why Bogle refers to this as speculative growth. It builds in what an investor thinks about the level of risk (or speculation) fellow market participants will be willing to pay in the future. Of all three factors in the formula, this is, without a doubt, the hardest to get right. So many factors drive investor attitudes. Having said that, we firmly believe that utilizing a long-term average and then assuming a regression to the mean can guide whether you think P/E ratios will increase or decrease.
So, how does the model work? For example, let’s see how the model would have predicted the S&P 500 for the period 2010 - 2020.
- Warren Buffett
In the fall of 2015, Jack Bogle and Michael Nolan published an article[1] which discussed how Sir William Occam’s Law of Parsimony could be utilized to create a model that could estimate reasonable expectations for capital market returns. The model was, indeed, quite simple. In the article, Bogle and Nolan described it as thus:
Projected Return = Starting Dividend Yield + Earnings Growth Rate + % Change in PE Ratio
Bogle labeled each of these factors as dividend return, investment return, and speculative return. He labeled the first two as “investment” returns and the last as “speculative” returns.
Dividend Return: is the one inarguable factor in the model. For instance, today’s (July 26, 2024) S&P 500 yields are 1.32%, considerably below the 50-year average of 2.8%.
Earnings Return: It is impossible to say what market (or your portfolio’s) earnings will be five to ten years from now. For instance, the S&P 500’s earnings per share grew an inflation-adjusted 2.4% a year in the 1970s, fell 0.7% in the 1980s, grew 4.7% in the 1990s, contracted 1.9% in the 2000s and dramatically increased by 8.7% in the 2010s. Some feel it is best to use the 50-year average, while others add or subtract by where they think we are in the economic cycle. It’s up to each investor to derive the number they believe best represents the future of earnings.
Of course, earnings can’t be measured without factoring in inflation. One of the more sound ways we’ve seen of calculating this is the difference in yield between 10-year Treasury notes and 10-year inflation-indexed Treasurys. As of today, this would show an estimated future inflation rate of -1.6%. By adding the dividend rate plus the earnings growth rate and subtracting the inflation rate, an investor gets the estimated “investment” return of the markets or their portfolio.
P/E Ratio Change: The change in P/E ratios reflects how much investors are willing to pay for stocks. Higher P/E ratios suggest that investors are willing to pay more for future growth while decreasing P/E ratios reflect that investors will pay less for growth. This is why Bogle refers to this as speculative growth. It builds in what an investor thinks about the level of risk (or speculation) fellow market participants will be willing to pay in the future. Of all three factors in the formula, this is, without a doubt, the hardest to get right. So many factors drive investor attitudes. Having said that, we firmly believe that utilizing a long-term average and then assuming a regression to the mean can guide whether you think P/E ratios will increase or decrease.
So, how does the model work? For example, let’s see how the model would have predicted the S&P 500 for the period 2010 - 2020.
Even with 20/20 hindsight, we can see the formula was off considerably compared to actual returns. This means one of three things: The actual earnings growth rate was considerably higher, the P/E annual increase was more significant, or a combination of both.
Why This Matters
I bring Bogle/Nolan’s model up because it’s a great way to see what’s happened to the Nintai portfolio since its inception. We can divide the portfolio performance into two phases – “Super Alpha” (2018 – 2020) and “Definitely Not Super Alpha” (2021 - 2024). I should point out that the portfolios seem to be leaning back to the “Super Alpha” model this quarter. My fingers are crossed.
In the Super Alpha period, the Bogle/Nolan model shows two variable factors in their formula (earnings growth and speculative growth), estimating extraordinary growth. Earnings growth is estimated at 10.7%, and the PE expansion growth exploded at 11.2%. Combined with the 1.07% dividend yield, the estimated annual growth was 23.2%. As you can see, nearly 50% of the estimated growth came from expansion in the P/E ratio. The portfolio’s P/E ratio went from 17.7 in 2018 to 24.7 in 2021.
In fact, the formula overestimated growth for the period. The model showed 23.2%, while actual portfolio growth came in at 19.8%. The Nintai portfolio enjoyed extraordinary earnings growth (investment return) and P/E growth (speculative return).
Why This Matters
I bring Bogle/Nolan’s model up because it’s a great way to see what’s happened to the Nintai portfolio since its inception. We can divide the portfolio performance into two phases – “Super Alpha” (2018 – 2020) and “Definitely Not Super Alpha” (2021 - 2024). I should point out that the portfolios seem to be leaning back to the “Super Alpha” model this quarter. My fingers are crossed.
In the Super Alpha period, the Bogle/Nolan model shows two variable factors in their formula (earnings growth and speculative growth), estimating extraordinary growth. Earnings growth is estimated at 10.7%, and the PE expansion growth exploded at 11.2%. Combined with the 1.07% dividend yield, the estimated annual growth was 23.2%. As you can see, nearly 50% of the estimated growth came from expansion in the P/E ratio. The portfolio’s P/E ratio went from 17.7 in 2018 to 24.7 in 2021.
In fact, the formula overestimated growth for the period. The model showed 23.2%, while actual portfolio growth came in at 19.8%. The Nintai portfolio enjoyed extraordinary earnings growth (investment return) and P/E growth (speculative return).
So what happened in the next (“Definitely Not Super Alpha”) period: 2021 - 2024? The Bogle/Nolan model does a great job of showing the reasons for underperformance during this time. In essence, the portfolio demonstrated solid investment returns through solid earnings growth (though at a slower rate) and a near-collapse in speculative return with a significant decrease in the P/E ratio during the period.
During the period, the S&P 500 outperformed the Nintai portfolio by nearly 9.8% annually. This was achieved in two ways. While the Nintai portfolio earnings growth in the formula dropped from 10.7% to 3.6%, the S&P saw its earnings grow steadily, if not increase. Additionally, the speculative (P/E growth) return in the Nintai portfolio dropped to a negative 3.8% while the S&P 500 increased again.
During the period, the S&P 500 outperformed the Nintai portfolio by nearly 9.8% annually. This was achieved in two ways. While the Nintai portfolio earnings growth in the formula dropped from 10.7% to 3.6%, the S&P saw its earnings grow steadily, if not increase. Additionally, the speculative (P/E growth) return in the Nintai portfolio dropped to a negative 3.8% while the S&P 500 increased again.
During Nintai’s most successful years, the portfolio’s investment return (Dividend % Rate + Earnings Growth Rate) and speculative return (the P/E ratio growth rate) dramatically outperformed the S&P 500. Not only were the portfolio companies growing faster than the S&P 500, but investors were willing to pay more than the index. The exact opposite happened in the past several years. Investment return has slowed, and investors are not willing to pay as much for those earnings.
Conclusions
While not perfect, Bogle and Nolan’s performance prediction model is pretty nifty – and simplistic – to estimate how your portfolio will perform over an extended period. Using historical data with some educated guesses on where we are regarding economic and market cycles, an investor can make an educated guess on how their portfolio might perform in the future. Additionally, it’s a straightforward tool to demonstrate how and why portfolios outperform and underperform over specific periods. I highly recommend setting up a model and giving it a try yourself. If nothing else, it’s an outstanding tool to teach investors what drives market returns. And you can’t knock that.
I look forward to your thoughts and comments.
Disclosures: None
Conclusions
While not perfect, Bogle and Nolan’s performance prediction model is pretty nifty – and simplistic – to estimate how your portfolio will perform over an extended period. Using historical data with some educated guesses on where we are regarding economic and market cycles, an investor can make an educated guess on how their portfolio might perform in the future. Additionally, it’s a straightforward tool to demonstrate how and why portfolios outperform and underperform over specific periods. I highly recommend setting up a model and giving it a try yourself. If nothing else, it’s an outstanding tool to teach investors what drives market returns. And you can’t knock that.
I look forward to your thoughts and comments.
Disclosures: None
[1] “Occam’s Razor Redux: Establishing Reasonable Expectations for Financial Market Returns,” The Journal of Portfolio Management Vol 42 Issue 1, Fall 2015
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