A brief look at multiple expansion and its affects on returns.
Buffet doesn't pay up for a reason
A word on value vs growth
We can’t talk about the significance of multiple expansion without talking about value investing more broadly.
Some investors don’t mind paying a lofty multiple for a company while others are a bit more tight fisted when it comes to paying for a stock. I tend to feel much more comfortable buying cheaper stocks that have potential to re-rate higher. This is just my nature, I love a bargain. However, I also don’t mind buying a growth stock with a higher multiple so long as the price is reasonable relative to future growth prospects.
In some sense, all investors are growth investors, but not all investors are value investors. Put another way, we all want growth but some of us aren’t willing to take the risk of paying up for it. Value investors tend to put a little more emphasis on todays cash flows and are skeptical of paying up for the future cash flows of a business.
Growth investors on the other hand tend to put a larger emphasis on the growth prospects of business and therefore pay much more attention to revenue growth and the potential future cash flows of the business. They don’t mind paying a lofty multiple so long as the company grows into the multiple.
Investors—including myself— have always wrestled and debated which strategy is better. I try not to be overly dogmatic about these things because I’ve seen research and evidence to support just about every investing strategy there is. The Nobel prize winner Ronald H. Coase once said “If you torture the data long enough it’ll confess to whatever you’d like.” And this is especially true in the world of investing where money and ego go together like peanut butter and jelly. We all seem to find perfectly organized data that just so happens to confirm what we already wanted to believe, imagine that!
So, as I’m presenting you the case for value investing in about 10 seconds, keep in mind, I could also easily find studies that show the opposite. And really, at the end of the day, I don’t like value investing because of historical data, I prefer it because it suits my personality better and it’s a logically consistent way to invest. Regardless heres some historical data.
The case for value
Value has been shown to outperform growth stocks in various different studies. Below is a graph from an article by Dimensional Fund Advisors on the historical performance of value investing. You can see that value has outperformed growth by roughly 4.4% on average since 1927. It obvious that since the GFC growth has done quite well under low interest rates. But zooming out to a multi decade perspective, value begin to pull ahead.
This doesn’t mean that a portfolio of a bunch of random low P/E stocks would have magically outperformed a portfolio that invested in Amazon at the IPO. These kinds of back tests look at averages and large collections data, they don’t account for the unfortunate scenario where someone dumped 50% of their portfolio into a few hairball value traps. Nor don’t they account for the lucky guy who dumped 50% of his portfolio into Amazon at the IPO. In fact, theres no shortage of value traps out there and no shortage of growth stocks that will absolutely outperform over the next 10 years. But in general, if you’re selective and thoughtful, the evidence suggests that value can potentially outperform over the long term (decades). And there is sound reasoning behind it.
Here is an excerpt from the article sited above by Dimensional Fund Advisors,
“Value investing is based on the premise that paying less for a set of future cash flows is associated with a higher expected return.”
How true this is.
When you buy a business, you’re buying a claim on the future earnings of that business. So paying a low multiple for those earnings increases the odds of a higher return, and multiple expansion is really just the icing on the cake.
Now a word on multiple expansion.
Historical returns from multiple expansion
JP Morgan analyst Meera Pandit explains how S&P returns have partially been driven by multiple expansion over the last 35 years.
“Since 1989, earnings growth has driven 56% of returns, compared to just 25% for multiple expansion and 19% for dividends. However, by calendar year, in 18 of the last 35 years, the contribution from multiple expansion outpaced the earnings growth contribution.”
So the market has returned around 12.3% per year over the last 35 years and multiple expansion is responsible for 2.5% of that. Over a 35 year period thats actually a huge difference.
Just to put it into perspective, if you were to remove that multiple and only rely on earnings growth and dividends, a $100k investment would have turned into $2.65 million by year 35. But if you were to add back 2.5% for multiple expansion, that same investment would be worth almost $5.8 million, almost 120% more. It’s incredible what an additional 2.5% can do over a long period of time.
A few hypothetical examples of multiple expansion
Obviously the returns derived from multiple expansion are heavily dependent on the time frame and the total increase in multiple.
Below represents the returns that you would expect from multiple expansion alone over various periods of time. The Y axis represents investment periods between 10-30 years. The X axis represents a multiple increase of between 50% - 200%.
If a multiple increases by 50% over a 10 year period, you’d still receive a 4.1% boost in your returns. If it tripled you’d be sitting on an 11.6% return, this is all on top of whatever returns could be generated by earnings growth.
This brings up another important discussion. Earnings growth combined with multiple expansion.
Earning growth and multiple expansion
Now, I understand looking at multiple expansion alone doesn’t do us any good. No one is ever going to come across a company, with no growth, that expands its multiple by 200% over a 30 year period. So let’s examine something a bit more realistic.
Company B grows earnings modestly at 10% annually for 10 years and the multiple gradually doubles in that same period from 10x to 20x.
We see that in the early years the returns are more dramatic but they cool off as time passes. But even with diminishing returns, company B would still have generated a 17.9% CAGR by year 10. This is a great return considering earnings only grew at 10%. The way I see it is that extra 7% - 8% provides you with the opportunity to be wrong and still do ok.
With the added multiple expansion, a $100k investment would be worth $519k. Thats actually really good.
Note: A multiple doesn’t usually expand in a neat upward trajectory like a stairway to heaven. Most likely it’ll zig and zag, but if the company is perceived as higher quality with a better value proposition, the market will reward the company with a higher multiple over time.
Pros and cons of relying on low multiples
Now that I’ve discussed the connection between value investing and multiple expansion, I want to discus some of the pro’s and cons of these types of stocks.
Rocket ready: Sometimes when cheap stocks catch fire the returns can be quite spectacular with minimal risk. Apple traded at 15x earnings in December 2018 (when I took a position) and just 3 years later it traded at almost 30x earnings. From trough to peak it was up around 350% as EPS grew and the market re-rated it higher.
Margin of safety: Often times cheaper stocks represent weak investor expectations. When expectations are already low and something unfavorable happens, there tends to be less reaction by the market.
Favorable for buybacks: A company with a P/FCF ratio of 10, is able to potentially buyback about 10% of the company. A ratio of 20 reduces this down to 5%. Sometimes companies with low multiples are able to buyback substantial amounts of their stock which can produce incredible EPS growth and shareholder returns even if growth is minimal. Again, Apple in 2018-2021 is a perfect example of this. In that period, revenue grew 38% and earnings grew 59% , however EPS grew 89% because they were able to reduce their shares outstanding. The combination of a low P/E and buybacks can produce amazing returns even if growth is less than stellar.
Cons
Multiples are unpredictable: I try not to put too much faith in the future multiple of a business because it’s hard to predict what the market will pay for a company in the future. I don’t want to assume the market will pay what I want it to. The market can swing from extreme pessimism to optimism, bidding stock prices down and up in short period of time.
Expansion returns are time sensitive: Expansion returns are more effective in the short term. Over long periods of time valuation becomes less important, but not unimportant.
Lofty returns can be taken back: If the market rewards you by doubling the P/E of your stock, it can certainly also punish you by cutting it in half just as quick.
Conclusion
As many investors have pointed out before me, investment returns are driven by some combination of growth, multiple expansion and cash returns (buybacks and dividends.) Each company you come across may offer a different mixture of these. Some will offer incredible growth with no buybacks or multiple expansion. Others are like fallen angels that are printing cash for buybacks and have potential to expand their multiple. Either way, my job as an investor is look for stocks that could offer greater returns than the S&P over time. Otherwise I should just buy the index and spend my time surfing instead of reading 10k’s, like a nerd. ; )
Thanks for reading! Consider subscribing if you like the content.