Friday, August 3, 2012

ETF investing does not make you rich

I am currently reading a truly excellent book on investing; it is not only describing the many topics discussed on this blog in a systematic fashion rather than in the opportunistic chaos of a blog, it helps you set up a stock market and bond portfolio that will perform over the years. The book is the latest edition of William J. Berstein’s ‘The Four Pillars of Investing’.

One of the topics not discussed on this blog is evaluating a stock in terms of the net present value of its  future dividend income stream. This technique was first proposed by Irving Fisher and rumour has it, that Warren Buffett also used to calculate investment value in terms of net present value of its future income stream. Irvin’s method is official called: DDM or Discounted Dividend Model. You may have come across the world famous future value/net present value equation which goes as follows: 
         FV=PV(1+i)^n

Where:
FV  = Future Value of an investment
PV = present Value of an investment
i   = the discount rate (or rate of desired return on investment) per year
n = is the investment life expressed in years.

Thus a dividend of $3 to be received 5 years from now (FV = $3) and assuming an interest rate or required ROI (i or further down it is: DR) of 10% would be worth today $1.86 using the equation below:
                        PV=FV/(1+i)^n



You could not only calculate the net present value of each dividend you will receive over the next five years, you could do so for an infinite number of years (assuming your investment never terminates, i.e. the ultimate Buy&Hold).  When you add up all those to net present value converted dividends then the sum would represent the share's (net present) value.  This would entail a lot of calculator math, but fortunately, mathematicians found that the answer can be expressed as a very simple equation:

                    MV=PD/(DR-DGR)
Where:
                             MV  = Market Value (of a share)
                             PD  = present or today's dividend per share
                             DR  = aforementioned discount rate
                            DGR = Dividend Growth Rate

For the Dow Jones Industrial Index, the dividend growth rate historically averages 5% (more or less the same as nominal GDP growth of the U.S. economy). The current dividend yield is 2.5% or $319.73 and today’s index price is: $12,789 (the Dow is 12,789 right now - just put a dollar sign in front of it).
Thus if an annual return on investment (DR) is required of 10%, then according to the DDM the DOW should be at $6,394 rather than $12,789.  Thus, the expectation of a return on investment of 10% per year is likely unrealistic. Based on its current value, a ROI (DR) of 7.5% should be a more reasonable expectation.

You may manipulate this DDM equation to express the expected market return (DR) as follows:
                       DR=DY+DGR
Where     
                                DY = Dividend Yield (PD/MV)

I know, the math is excruciating in its complexity J). Today’s DY = 2.5% and the DGR=5% so the expected annual rate of return or DR is 7.5%.
Of course, the Dow Jones fluctuates due to a hyper emotional investment community and as such is on a day to day basis completely unpredictable . Howeverrrr, over the long term, if you invested today in the Dow Jones Spyder ETF (DIA-N) according to the above equation, officially known as the Gordon Equation, your annual return should average 7.5% with all emotions cut out of the estimate.

Thus if you saved $10,000 per annum for 25 years and invested it in DIA-N with a return of 7.5%, your investment would be worth $679,778.  A tidy sum assuming there is no inflation and no taxes. So let’s assume 3% inflation and a marginal Alberta tax rate of 38.8% or a 19.9% rate on capital gains (lets forget about the taxes on the dividends right now).   So taxes are $85,525 the remainder being $594,253. Discounting $594,253 at 3% inflation, the net present value of your original investment (25 years x $10,000 = $250,000) is: $283,818.  You basically broke even in terms purchasing power.
This is one of the significant observations made by Bernstein, that investing in the stock market only protects the purchasing power of your original savings. Basically it is a postponement of today’s spending to spending 25 years from now. Do I agree with it? Not necessarily. I have run passively managed portfolios for my children. I invested the money in their education trusts in a number of reputable diversified mutual funds and the results were indeed very mixed. The funds did their job but not brilliantly.

On the other hand, we have reviewed long term stock market performance on this blog or reviewed the work of Jeremy Siegel (which Bill Gross now claims to represent a ‘historical fluke’) or the work of Jim O’Shaughnessy that goes back to the early 1900s. These works indicate returns of 13 to 18% or 7% plus inflation.  Another non-emotional way of estimating the return to expect from a stock is to use its earnings yield instead of its dividend yield. 
After all, you the shareholder owns the entire profit not just the dividends. As such, not only do dividends grow but the retained earnings are added to the assets of the company. This should result in capital gains in addition to the dividends. So if we use Gordon’s modified equation and assume that earnings growth is as fast as the dividend growth while the Dow currently trades at a P/E of 13 or an earnings yield (EY) of 1/13= 7.6%  then return over the long term should be:
                              DR=EY+DGR
Where
                                EY = Earnings Yield (1/PE)

The result is DR = 7.6+5 = 12.6%. In this scenario of $10,000 annual savings over 25 years would be worth $1.46 million minus $241K in taxes with a NPV discounted for inflation (3%) of $583,316.  Since  one needs a net worth of around $1.5 million to retire (A Portfolio of Viable Investments) with some comfort I do not think that investing in the Dow Jones will make you very rich. Over the next while, we will discuss how we could try to become rich(er).

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