Motivation Warren Buffett Javier Estrada IESE Business School - - PDF document

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Long‐Term Trends (III):

Forecasting

Javier Estrada ADFIN – Winter/2014

• 1. Motivation
• Investing v. speculating
• 2. The Model
• The RDM (Returns Decomposition Model)
• 3. Forecasts
• USA and the World market

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – Warren Buffett “I never had the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two. But I think it is very easy to see what is likely to happen over the long term.”

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – John Bogle

“The performance of individual securities is unpredictable …, the performance of portfolios of securities is unpredictable on any short-term basis … Yet when we look at portfolios of securities on a longer-term basis, the unpredictable becomes far more predictable …”

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – John Keynes Enterprise Speculation



The activity of forecasting the prospective yield of assets over their whole life The activity of forecasting the psychology of the market

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – John Bogle

Investment Return Speculative Return



Initial dividend yield + Earnings growth Variation in the P/E

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – John Keynes

“It is dangerous … to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was”

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – Paul Samuelson

“You are a fool if you wake up each morning and say that the universe was born anew today with new rules. You are also a fool if you think that history can be read to teach necessitous lessons. The art of practical decision-making is to try to glean from experience what aspects of it are likely to have relevance for the future”

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation – Mark Twain

“History does not repeat itself, but it does rhyme”

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The RDM

–1 1 P–1 P1 P0 E0 , D0 E1 , D1

Period 1

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The RDM

–1 1 $100

E0 = $10.0 D0 = $4.0 E1 = $10.6 D1 = $4.2

$107.8

Period 1

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The RDM

• This is the RDM forecasting expression
• And this is a very good approximation
• In the previous example

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The RDM

• This approximation highlights the distinction

between investment and speculative return

• Where do long‐term returns come from?

Go

• Optimism/pessimism largely offset each other
• Returns are ultimately determined by DY and gE

Go

Investment return Speculative return

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA ($) – 2014‐2023

1900‐2009

Growth earnings 4.5% Average P/E 15.8

Jan/1/14

D/P 1.9% P/E 18.9 Growth earnings 4.5% ΔP/E (MR) −1.8% ΔP/E (RW) 0.0%

Assumptions

R1

MR  1.9%+4.5%−1.8% = 4.6%

R1

RW  1.9%+4.5%+0.0% = 6.4%

Historical (1900‐2009): 9.4%

5.5%

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA ($) – 2014‐2023

Jan/1/14

D/P 1.9% P/E 18.9

1900‐2009

Growth E 4.5% Avg P/E 15.8 Avg D/P 4.2%

Next 10 Years

Growth E 4.5% Δ(P/E) −1.8% or 0.0%

R1

MR = 4.6%

Don’t like it? Make your case …  g1

E =

?  Δ(P/E)1 =?  D0/P0 = 1.9%

R1 = 1.9% + ? + ? =?

Is it reasonable? R1

RW = 6.4%

5.5%

Go

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA ($) – 2014‐2023

• If you have an expectation for returns
• Ask what g1

E and Δ(P/E) would yield that return

• And ask whether those values are reasonable

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

World ($) – 2014‐2023

1973‐2013

Growth earnings 7.8% Average P/E 16.9

Jan/1/14

D/P 2.4% P/E 16.4 Growth earnings 7.8% ΔP/E (MR) 0.3% ΔP/E (RW) 0.0%

Assumptions

R1

MR  2.4%+7.8%+0.3% = 10.5%

R1

RW  2.4%+7.8%+0.0% = 10.2%

Historical (1973‐2013): 10.1% 10.3%

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Appendix

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA (S&P) – Nominal Returns

158 53 303 −1 137 482 111 75 400 433 −9

Avg: 9.4%

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA (S&P) – Starting D/P

Avg: 4.2%

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA (S&P) – Growth in Es & Ds

Avg(E): 4.5% Avg(D): 4.4%

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

USA (S&P) – Change in P/E

R = 4.2% + 4.5% + 0.5% = 9.2% ≈ 9.4% Avg: 0.5%

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The RDM

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

The ‘Building Blocks’ Model

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Expectations

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