Rate Of Return On Capital – Our Best Guess

Rate Of Return On Capital – Our Best Guess

Rate Of Return On Capital – Our Best Guess by Greg Dowdall, Burgundy Blog

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Investors often have a notion about what is an acceptable or desired rate of return on their capital. This rate of return is typically expressed in percentage terms. For example, “I would like to make an 8% return on my money.” This desired rate of return could be based on a number of factors, such as:

  • What an investor believes to be fair compensation for assuming various investment risks
  • Extrapolation from past equity market returns
  • A required return to meet a specific investment objective

It is our opinion that selecting a nominal return benchmark like 8% to measure and judge the performance of a portfolio (or an asset manager) is not always useful. It is an investor’s “real” or after-inflation return that matters. Earning an 8% annualized return on your capital when your cost of living is increasing by 10% annually means that the future purchasing power of your investment capital is actually shrinking over time. Alternatively, earning a 6% annualized return on your capital when your cost of living is increasing at only 2% annually means that the purchasing power of your capital is growing over time. Sometimes six is more than eight – it depends on the other conditions.

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We believe investors should have some conceptual framework for judging whether their portfolio (and their asset manager) is producing an acceptable rate of return. We also believe that this framework should have a defined time horizon over which success or failure will be measured.

Which bring us to circumstances of today. What should investors consider an acceptable rate of return going forward? Well, let’s examine the state of the world:

  • Price/earnings multiples (or stock market valuations) are trading slightly above their long-term averages in most developed markets, suggesting equities are fully or modestly overvalued in a historical context
  • Globally, interest rates are at historically low levels
  • Most of the world is experiencing mild inflation and in some cases deflation
  • China, the world’s second-largest economy and a key driver of global economic growth over the past decade, has slowed from its breakneck pace of the last decade.

While not an exhaustive list of considerations, these circumstances lead us to conclude that, over the next five to 10 years, nominal returns in global equity markets are likely to be lower than their long-term historical averages. This is not a terrible outcome, provided inflation remains at low levels. The real (after-inflation) return is still positive under these assumptions.

We suggest nominal return expectations for broad equity market indices in the 5-6% range over the medium term.  That is our best guess, and it is only a guess because equity markets have a habit of turning forecasts for the future into the fodder of the past. To many current and prospective investors, these future return expectations seem low. In presenting these expectations, we are not trying to scare away new potential clients by appearing overly conservative in our outlook nor are we trying to set an artificially low hurdle rate so that we can exceed investors’ expectations. This is simply an acknowledgement of the current investment climate and its potential impact on future capital market returns. To put it another way, past investment returns are no guarantee of future investment performance, and expectations should remain in check.

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