In a now famous presentation by Mr. Buffett in Idaho in 1999, he stated he felt the most probable return in the next 17 years for equity investments would be 6%. Upon reading this, I asked myself where did he get this number from?
The graph below I believe goes a long way in answering that question. It shows explicitly the 15 and 30 year compounded annual growth rates of the S&P index using data from 1927. The fifteen year CAGR average is 6.93% according to the dataset we collected. Realising the large premium to valuations relative to historic standards, Buffett was willing to bet markets would have to show below average returns in the next decade and a half to ensure earnings caught up with valuations. How right he was.
We can clearly see the mean reverting properties of the equity markets. The data seems to suggest that the equity markets exhibit a cycle like behaviour that requires 35 -40 years to go full circle. Seventeen years would be half the cycle: historically speaking, we seem to be about two thirds through this down cycle. We therefore find comfort in the fact we see markets being overvalued using our valuation techniques, they seem to be well aligned with what long term pricing data would suggest.
Going forward, we remain cautious in our estimates for earning growth due to macro factors (please see "rare macro view" entry in our sensible investing blog), the history of pricing patterns and the distorted increase in operating margins many sectors of the economy have experienced particularly strongly in the last 5/6 years. We remain focused on buying the equity of companies that are available at the market with pricing that considers such scenarios.
Yours sincerely,
Alessandro Sajwani
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