The Truth Behind Stock Prices

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Tensions in the Ukraine pushed stocks lower. Solid earnings sent markets higher. Manufacturing data weighed on equities.

On a day-to-day basis, you'll hear all sorts of explanations for why stocks move one way or another. But what about over the longer term? What factors really drive equity prices over the long haul? And, perhaps most importantly, can we quantify them?

A 2010 study from MSCI Barra, entitled "What Drives Long-Term Equity Returns?", attempted to do just that -- and its findings likely aren't what you'd expect.


Barra (whose market indices are widely used by investors around the world) studied equity returns from 1975-2009 in a variety of markets, and broke down those returns into several components. The major ones: inflation; real book value growth (i.e., how much the company's underlying business and assets grow); price-to-book growth (how the amount of money investors are willing to pay for every dollar of that book value changes over time); and dividend income.

The results: According to Barra, the most significant of those components is inflation, which accounted for 4.2 percentage points of the MSCI World Index's 11.1% return from the start of 1975 through Sept. 30, 2009. The second biggest factor: dividend income, which accounted for 2.9 percentage points. Real book value growth and price-to-book growth accounted for 2.1 and 1.5 percentage points, respectively. The results were similar for many of the markets within that world index, including the U.S.

What that indicates is that over the long run, about two-thirds of the stock market's returns are the result of inflation and dividend payments -- two un-sexy factors to which many stock investors don't give enough thought.

When it comes to inflation, the work of contrarian guru David Dreman supports just what an impact it can have. Dreman, whose writings are the basis for one of my Guru Strategy computer models, has called inflation a "virus" that permanently entered the investment world after the Second World War. He found that over the long term, inflation eats away tremendously at the return of fixed-income investments like bonds or Treasury bills. Stocks, however, can draw on increasing earnings streams as companies raise prices and increase profits to keep up with inflation. Inflation is thus, to some extent, built into the companies' bottom lines, and, in turn, into stock prices as well.

As for dividend income, the implications are clear: While most investors today focus on stock price appreciation, good ol' dividend yield shouldn't be ignored in any market environment.

Currently, long-dormant inflation has begun to pick up a bit. And, strong yields are tough to come by, both because of the downward trend we've seen in dividends over the past couple decades and because the ultra-low-interest-rate environment has led many yield-hungry investors to bid up the price of high-dividend picks -- currently only about 115 stocks in the market get approval from my Guru Strategies and yield 3% or more. With that in mind, here are a few of the high-yielders that do get approval from my models, and which should have the pricing power to capture inflation-driven gains.

Chevron ( CVX ): Energy companies are a good inflation hedge, and my James O'Shaughnessy-based model sees value in this California-based oil and gas giant ($254 billion market cap), which is also involved in the lubricant, petrochemical products, geothermal energy, and biofuels markets. When looking for value plays, O'Shaughnessy targeted large firms with strong cash flows and high dividend yields. Chevron is plenty big enough, and it has an impressive $18.25 per share in cash flow (more than 10 times the market mean). It also sports a solid 3.2% yield, all of which help it pass the O'Shaughnessy-based model.

The Coca-Cola Company ( KO ): The Atlanta-based beverage giant ($179 billion market cap) is a longtime holding of Warren Buffett's, in large part because of its "durable competitive advantage". That advantage is due to its huge brand recognition and size, which give it the sort of pricing power that allows it to raise prices if inflation hits.

While Buffett has long liked Coke, it's my O'Shaughnessy model that is high on its shares right now. The strategy likes Coke's size, $2.36 in cash flow per share, and 3% dividend.

Kellogg Co. ( K ): Some have speculated that Buffett's Berkshire Hathaway might be interested in buying this Michigan-based food giant, whose well-known brands and products include Rice Krispies, Eggo, and Pringles. My Buffett-inspired model thinks Berkshire would be wise to give Kellogg (3% dividend) a long look. The firm ($23-billion market cap) has upped earnings per share in all but one year of the past decade; has averaged a stellar 43.2% return on equity over the past 10 years; and has enough annual earnings that it could pay off its long term debt in less than three years if need be, all of which are very "Buffett-esque" qualities. And, because it sells consumer staples with big brand names, it should have good pricing power.

Unilever ( UL ): This Netherlands-based maker of home goods and food products counts Lipton, Hellmann's, Dove, Slim-Fast, and Vaseline among its big brand names. The O'Shaughnessy-inspired model thinks it's a good value play. The strategy likes Unilever's size ($130 billion market cap), $3.21 in cash flow per share, and solid 3.3% dividend yield.

BASF SE ( BASFY ): This Germany-based chemical company offers a variety of products for a variety of industries. Its portfolio ranges from chemicals, plastics, and performance products to crop protection products to oil and gas industry products.

BASF gets high marks from my Peter Lynch-based model. Its 16.4% long-term earnings-per-share growth rate (using an average of the three-, four-, and five-year rates) and high sales (nearly $100 billion in the past year) make it a steady "stalwart" according to this model. Lynch famously used the P/E-to-growth ratio to find bargain-priced growth stocks, adjusting the "growth" portion of the equation to include dividend yield for stalwarts. When we divide BASF's 14.8 price/earnings ratio by the sum of its long-term growth rate and dividend (3.5%), we get a PEG of 0.75. Anything under 1.0 is considered a good value to this model.

I'm long K, CVX, and BASFY.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: CVX , KO , K , UL , BASFY

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