Macro Factors that Affect Long Term Investment Returns

Buffett’s Factors that affect long term investment returns in the stock market on a whole, as opposed to individual companies:

1) Interest Rates affect the intrinsic value of every asset under the sun, with even the most fractional change. Anything from rental property, to the local corner shop, to Apple Incorporated. The reason is simple, and it’s why we’re happy to pay slightly higher multiples for stocks when current interest rates are low. If an investment involves laying out money today, to receive more money in the following years, the interest rate will directly affect the rate at which we’re happy to accept “jam tomorrow”, opposed to jam today. If I can achieve 10% on long term risk-free bonds, the intrinsic value of an alternative to an investor will be different than when those same bonds yield 3%.

Another way of thinking about it is this: imagine interest rates were negative. If you were charged 2%, or 5%, on all your capital that wasn’t tied up in the stock market. As interest rates move from -2%, to -5%, you’re happy to accept a lower and lower earnings yield on your stocks to avoid the charge. The same applies when interest rates move from 10% to 5%, productive assets become more attractive. That applies to the stock market on a whole as well as companies.

2) GDP Growth, After-tax Profit Growth, and the relationship between the two. In the long run, no investment asset can grow faster than its earnings do. “The absolute most that the owners of a business, in aggregate, can get out of it in the end–between now and Judgment Day–is what that business earns over time.”

In broad market terms, a country’s GNP is turnover, and after-tax profits are EPS. It follows that after-tax corporate profitability in the long run cuts as a % of GDP, in other words the “net profit margin”. The two normally grow together – in a bull market, stock prices rise at a pace that out-strips business value growth, often in the first leg because market prices need to “catch up” to previously ignored growth. Similarly there are periods where market prices don’t reflect the growth in intrinsic value, or where the market is flat compared to growing GDP. All an investor can do is judge whether the market level is an acceptable price considering the current levels of GDP, the current levels of after-tax profits, the expected rate at which both can grow, and whether the current margins of profits-GNP will change over time.