Cult of Equity isn't dying: Stocks will still outperform economy

Everybody and everyone has an opinion on future equity prices and returns. For pension funds, retirees, investors and everyone else, this is a huge worry as low yielding debt and 'expected' low equity returns will cause many problems and disappoint many investors. Now there is renewed worries that equities are more or less 'dying' as an asset class.

Bill Gross - the author of "Everything You Know About Investing Is Wrong" and head of US investment firm PIMCO, which is the world's largest bond investor - recently stated that the 'Cult of Equity' was dying because the past 100 years inflation-adjusted equity returns could not continue, and that equity returns could not continue to outpace economic growth. Here is his reasoning, in an excerpt from the August PIMCO newsletter:

"If wealth or real GDP was only being created at an annual rate of 3.5% over the same period of time, then somehow stockholders must be skimming 3% off the top each and every year. If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)? The commonsensical “illogic” of such an arrangement when carried forward another century to 2112 seems obvious as well. If stocks continue to appreciate at a 3% higher rate than the economy itself, then stockholders will command not only a disproportionate share of wealth but nearly all of the money in the world! Owners of “shares” using the rather simple “rule of 72” would double their advantage every 24 years and in another century’s time would have 16 times as much as the sceptics who decided to skip class and play hooky from the stock market."

It is a scary thought to think that equities 'should' return only around 3 or so percent. At quick glance, his argument makes sense, how can equity returns keep outpacing economic growth?  But it does and it will continue to happen due to one reason; the rebalancing of debt and equity! To demonstrate my proof I will setup three different scenarios of a simple world growing at 3% with one factory producing only widgets with no inflation, to keep things as simple possible.

Three scenarios

In scenario 1, the factory is financed entirely with $100 of equity. The factory makes 100 widget in the first year, the variable cost of the widget is $0.9 and charges $1 per widget. Therefore in the first year, the company earns $10 profit over a capital base of 100, so the return on equity is 10%. Now in the next year, due to the economic growth of 3%, the economy demands 103 widgets, which creates 10.3 in profits. So in the second year the return on equity is  10.3/110= 9.36%. Are you still following me?

Now if you continue this over an infinite period of time, return on equity will eventually approach the growth rate of the economy of 3%. So in this sense Bill Gross was somewhat correct, given an economy only funded with equity, over infinite periods return on equity will approach economic growth due to growing equity base.

Now we can add debt into our little world, call it 'Scenario 2'. So let's assume that debt and equity finance this little factory. If we finance the factory this way it will take even longer for the equity returns to reach the 'equilibrium' return on equity of 3%. This is due to the fact that the debt will act as leverage on equity, creating larger returns for equity holders, much like it would for a regular company finance with debt and equity.  But in infinite period of time return on equity will still reach 3%, and the equity base will become infinitely bigger than the debt potion. So from 'Scenario 2' we can see that debt definitely has an impact on equity returns. This is what Bill Gross assumes that the world is like...

Using Scenario 1 and 2, we can somewhat see how Bill Gross could be logically correct. But his argument is unrealistic and this is why: he assumes that the relative equity and debt levels do not get rebalanced, meaning that the equity base will quickly 'overpower' the debt portion which will lead to equity returns to equaling economic growth. But economies, companies, the world do rebalance their equity to debt ratio! This is not a wild assumption, it is simply the truth. In 'Scenario 3' if you finance the company with debt and equity initially, and rebalance the financing at certain points so that debt and equity can maintain the same ratio as it did during the first year, then you will have equity returns that outpace the rate of growth of the economy! The explanation is actually that simple. The more leverage you have (as long as the debt financing costs are not higher than the EBIT) the higher your equity returns will be; sound familiar?

It is easy to calculate that if you continuously rebalance the portion of debt and equity at a given, equity can continue to outperform economic growth, this is simply a mathematical fact  (you can take my word for it or you can calculate it yourself).

So don't worry investors, the cult of equity is not dying and shareholders are not skimming at the expense of lenders, laborers and government, Bill Gross is simply wrong if he assumes that equities cannot keep on outperforming the economy, because they have and they will.