Michael: Patrick, tell me about what the stock market has done during your lifetime.
Patrick: Well Michael I am 50 years old and was born in 1972. I have pulled up to see what has happened during that time and I got the numbers right here to give a little review.
So 1972, when I was born, what was the S&P.
What was the market at? 118.
Earnings on the S&P, what was it at? $6.17.
What was inflation? 42.
So let’s fast forward those 50 years to where we are at now.
The S&P was 118 and now it’s 4,200. That is 35x and that is through right now.
The earnings on the S&P was $6, now it is $215. That is 35x.
You see the parallel there? Earnings drive stock prices. 35x and 35x.
When stock prices are down, they eventually reflect the earnings of the companies.
Now the dividends were $3.19, now $65. So dividends on the market have grown 20x.
Inflation was 42 and now it’s 300 so inflation is 7x. If you had your money invested in good companies for these 50 years, your money has grown 35x. The income that you can take from those companies if you just only took the income has grown 20x, 3x for inflation.
So it’s been a great 50 years and things have worked out if you retired 50 years ago kept spending the same amount of money, you’d be in good shape.
Michael: So that all sounds great, I think it sounds phenomenal. So let me ask you this. What did you have to endure if you were that investor that retired the day you were born? What did they have to endure with that period?
Patrick: Well these past 50 years, 3 times the market has gone down by half and they were all for good reason.
Going back to the first one, our country was at war. We had Watergate and our president resigned and we had huge inflation – down almost 50%.
The second time, the tech boom in 1999-2002 over a period of 3 years, I had already started in this business, 50%.
The third time, the financial crisis, we call the biggest, 57% from the high point to the low point.
All three of those crises recovered fairly quickly and went on to new highs, but we did have to endure some pain. If you had a million dollars that went to $500,000, you had to stick with it. As it got back to a million and went on to new highs. There is always going to be bumps in the road.
Michael: So what we have learned, as long as you remain a long term oriented investor, you can expect stock market to outperform inflation over time. But you have to be willing to endure when the market goes down sometimes 50% and sometimes maybe even more.
Patrick: So if you didn’t want to be invested in the market and into stocks. Say someone told you that you should be in bonds, any thoughts on that?
Michael: Well let’s take a look. Whenever we analyze investment performance, we want to make sure that we are doing it after inflation. Ultimately what matters to anybody is their purchasing power, what you can go out and spend your money to buy stuff on.
When you take a look at the stock market over the long term, it has returned 10% a year. Now inflation has averaged 3% so that nets out to 7%. Bonds on the other hand have averaged 6% a year. That is high quality corporate bonds. Over the long term 6%, netted against inflation is 3%. So ultimately if you choose to invest in bonds over stocks over owning great companies, you’re accepting half the return after inflation over the long term. That’s the cost of making that decision.
Patrick: So what I heard there is the nominal return is that term, 7 for stocks and 3 for bonds.
So the nominal after inflation for stocks has been double, is that right?
Patrick: So when you look at a company, say the biggest company in the S&P last year, Apple. They got a lot of cash. They are doing a lot of things. They issued some bonds and they sold that to the public and people invested in their bonds.
Why would a company like Apple issue bonds?
Michael: Well, if they are going to issue bonds to repurchase stocks, which in this case is what they did and what Tim Cook made completely clear in the prospectus when they sold the bonds. It is because they recognized the value of long term stock ownership. If I’m going to borrow money to go out and repurchase shares of my company, it’s because I recognized the value of owning the company. I recognized the value that buying over the long term can have.
Ultimately when you think about investing, there is two ways that you can invest. You can own or you can loan.
You can be an owner, meaning you buy shares of stock. Or you can be a loaner, meaning you give money to companies who are borrowing for investment. No company would borrow if they didn’t think that they could exceed the rate of return that they have to pay on the interest.
Every company out there when they issue debt, they are doing so because they believe that they are going to be able to generate a rate of return in excess of that cost in borrowing. That should be an indicator above all else that you want to own those great companies as opposed to loaning to those great companies over the long term.
Patrick: So I’ve looked at those numbers and I looked at that Apple sold 40 year bonds at a really low interest rate. I don’t know what happens with the latest iPhone or what happens with Tim Cook or the next CEO. The next 40 years I know being an owner of a company and getting whatever that return on Apple on the next 40 years. I’m pretty confident and comfortable on beating loaning them money at 2% for the next 40 years.
Being an owner and being a loaner. I rather be an owner, that sounds like the right thing to do.
Michael: I agree