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Why I'm not buying the "equities are dead" argument

August 21, 2012: 11:06 AM ET

Don't believe the naysayers -- stock market returns beat real GDP growth over time. It's all about cash flow.

By Jeff Westmont

FORTUNE -- Bond guru Bill Gross recently created a controversy when he proclaimed "the cult of equity is dying" and compared historical stock returns to a Ponzi scheme. His position is that since GDP for the last century grew at a 3.5% real rate, stockholders were effectively "skimming off the top" to achieve their actual 6.6% return. In his view, shareholder returns can't exceed real GDP growth over time. Yet total stock market returns include both capital appreciation and the impact of the deployment of corporate cash flows, including dividends. It is this latter component that enables investors to achieve returns in excess of GDP growth.

In effect, buying a share of stock is similar to buying a bond, but with more variable and uncertain cash flows. Net income available to stockholders is comparable to an interest payment, although one that can vary significantly over time. Corporations can either pay out this net income in dividends, reduce debt, repurchase stock or reinvest it in the business. In the latter two scenarios, shareholders either increase their share of future cash flows (due to an increase in ownership percentage) or own a growing and increasingly valuable corporation.

The importance of these cash flows in generating investor returns cannot be overstated. For instance, if an investor pays 15 times earnings for the market, she is effectively buying a bond with a 6.7% yield, albeit a highly variable one. Now assume a steady state economy where real GDP does not grow. In this scenario, corporations are probably not increasing their working capital or making capital expenditures in excess of depreciation. Thus, net income is a decent proxy for free cash flow (FCF). Investors should expect to receive 6.7% annually -- assuming a 100% payout ratio -- similar to how many master limited partnerships are structured. In this no-growth economy, aggregate real corporate valuations should remain constant, as corporate winners and losers offset each other. As a result, unless the aggregate real value of public corporations decreases materially over time (as discussed below), investor returns will significantly exceed GDP growth.

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The advantage stocks have over bonds is that if inflation rises, this net income payment stream should remain relatively constant in real terms (assuming corporations can match the rise in input costs with price increases). Moreover, if real GDP grows, companies can reinvest their FCF in expanding the business. While this in the short run will decrease cash flows available to investors, theoretically, over time, they will own a more valuable business.

In examining investor returns for the past century, one might have expected that investors would have earned closer to 10% annually (the market multiple in 1912 was about 15x, similar to today, implying a 6.7% earnings yield and adding the real 3.5% GDP annual growth as a proxy for the appreciation in corporate values). Yet actual returns were lower, which may be due to two reasons. First, the stock market at any one point in time represents only public companies and market indices (such as the S&P 500) generally include only large capitalization companies. Yet over time, some larger public companies lose market share to emerging private or smaller public companies (e.g. new companies and industries constantly emerge to replace established ones). Since investors (as represented by the indices) own these large public company "losers" and not the private or smaller public company "winners," it is not surprising that actual returns are lower than theoretically possible. Second, since the majority of corporate free cash flow is used for expansion and not to pay dividends, some of these capital expenditures are probably misallocated, particularly by companies in decline. In other words, management teams don't always make the best use of corporate cash flow.

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Gross may be right that future stock market returns will be lower than historical due to slower growth worldwide and his other compelling arguments. In addition, market multiples may contract, management teams may invest excess cash flow poorly or the number of public company "losers" could increase significantly. But there is nothing inconsistent with having total stock market returns greater than GDP growth, as long as cash flows are included in the calculation.

Jeff Westmont, a former investment banker, is the founder of Westwoods Capital, a consumer oriented hedge fund. He recently published his first book, Countdown to Jihad, a political thriller. 

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