Earnings Growth: The Two Percent Dilution via CSInvesting

William J. Bernstein and Robert D. Arnott

September – October, 2003


Two important concepts played a key role in the bull market of the 1990s. Both represent fundamental flaws in logic. Both are demonstrably untrue. First, many investors believed that earnings could grow faster than the macro economy. In fact, earnings must grow slower than GDP because the growth of existing enterprises contributes only part of GDP growth; the role of entrepreneurial capitalism, the creation of new enterprises,i s a key driver of GDP growth, and it does not contribute to the growth in earnings and dividends of existing enterprises. During the 20th century, growth in stock prices and dividends was 2 percent less than underlying macroeconomic growth. Second, many investors believed that stock buybacks would permit earnings to grow faster than GDP. The important metric is not the volume of buybacks, however, but net buybacks-stock buybacks less new share issuance, whether in existing enterprises or through IPOs. We demonstrate, using two methodologies, that during the 20th century, new share issuance in many nations almost always exceeded stock buybacks by an average of 2 percent or more a year.

Earnings Growth: The Two Percent Dilution – Introduction

The bull market of the 1990s was largely built on a foundation of two immense misconceptions. Whether their originators were knaves or fools is immaterial; the errors themselves were, and still are, important.

Investors were told the following:

1. With a technology revolution and a “new paradigm” of low payout ratios and internal reinvestment, earnings will grow faster than ever before. Real growth of 5 percent will be easy to achieve.

Like the myth of Santa Claus, this story is highly agreeable but is supported by neither observable current evidence nor history.

2. When earnings are not distributed as dividends and not reinvested into stellar growth opportunities, they are distributed back to shareholders in the form of stock buybacks, which are a vastly preferable way of distributing company resources to the shareholders from a tax perspective.

True, except that over the long term, net buybacks (that is, buybacks minus new issuance and options) have been reliably negative.

The vast majority of the institutional investing community has believed these untruths and has acted accordingly. Whether these tales are lies or merely errors, our implied indictment of these misconceptions is a serious one-demanding data.

This article examines some of the data.

Big Lie #1: Rapid Earnings Growth

In the past two centuries, common stocks have provided a sizable risk premium to U.S. investors: For the 200 years from 1802 through 2001 (inclusive), the returns for stocks, bonds, and bills were, respectively, 8.42 percent, 4.88 percent, and 4.21 percent. In the most simplistic terms, the reason is obvious: A bill or a bond is a promise to pay interest and principal, and as such, its upside is sharply limited. Shares of common stock, however, are a claim on the future dividend stream of the nation’s businesses. While the investor in fixed-income securities is receiving a modest fixed trickle from low-risk securities, the shareholder is the beneficiary of the ever-increasing fruits of innovation-driven economic growth.

Viewed over the decades, the powerful U.S. economic engine has produced remarkably steady growth. Figure 1 plots the real GDP of the United States since 1800 as reported by the U.S. Department of Commerce. From that year to 2000, the economy as measured by real GDP, averaging about 3.7 percent growth a year, has grown a thousandfold. The long-term uniformity of economic growth demonstrated in Figure 1 is both a blessing and a curse. To know that real U.S. GDP doubles every 20 years is reassuring. But it is also a dire warning to those predicting a rapid acceleration of economic growth from the computer and Internet revolutions. Such extrapolations of technology-driven increased growth are painfully oblivious to the broad sweep of scientific and financial history, in which innovation and change are constant and are neither new to the current generation nor unique.

Earnings Growth

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