income investing is, and how substantial is the “reinvestment risk.” And beyond bonds, it’s even

more up for grabs.

What rate of return is implicit in equity investing? Certainly we should look to more than just

returns over the last ten or twenty years for the answer. The rate of growth in corporate profits

provides a clue, but in the short run, changes in p/e ratios tend to swamp changes in profits.

In 1999, investors asked, “What’s been the return on common stocks?” and were seduced by the

11% answer propounded by authorities like Prof. Jeremy Siegel in his book, “Stocks for the

Long Run.” What they should have asked, however, is, “What’s been the return on common

stocks bought when the Standard & Poor’s 500 was priced at 29 times earnings?” (which it

was at the time). In other words, people made the mistake of believing that common stocks

have a single rate of return you can depend on, regardless of entry point. They forgot the great

extent to which the return on an asset is dependent on the price you pay for it.

In the March/April 1997 issue of the Financial Analysts Journal, Peter Bernstein set forth a

helpful way to consider returns from equities – one I’d thought about but had never seen in use.

He calculated returns on the S&P 500 for periods spanning widely separated dates between

which the p/e ratio didn’t change. He called the result “valuation-adjusted long-run equity

returns.” In December 2006, he published some interesting results. With the S&P 500 trading at

17.2 times earnings, he looked at four periods which had begun with the p/e at the same 17.2 and

found that the returns over those periods had ranged from 10.4% to 11.1%.

In other words, over periods when multiples were unchanged, the S&P 500 did deliver roughly

11%. And in the very long run, over the course of which the impact of p/e fluctuations is

watered down, stocks also have returned 11%. Thus it seemed reasonable for buyers of stocks in

1999 to expect returns of 11% per year. But they failed to think about what might happen if p/e

ratios fell in the short run.

It shouldn’t take a Ph.D. (or even an MBA) to know that if you buy the S&P in 1999 at a p/e

ratio of 29, one of the highest multiples ever seen, the p/e ratio could decline and the resulting

return could be below 11% – well below 11% if it happened quickly. In 1999, investors derived

excessive comfort from an optimistic consensus that was based on long-run data. But in 2002,

they were licking wounds inflicted in the short run. It’s worth noting that for the seven years that

ended March 31, 2007, the annualized return on the S&P 500 was 0.9%. So much for the

crowd’s certainty regarding 11%.

And what about the return on private equity? Before saying what it’ll be, investors should think

about where returns come from. Some markets derive their returns from an underlying process.

As far as I’m concerned, owning interests in money-making companies and income-producing

real estate has such an underlying basis for returns, whereas owning gold and art does not.

Companies produce profits, and thus buying interests in them represents buying into a stream of

returns. When a private equity fund buys a company today at nine times EBITDA (which, let’s

say, equates to eleven times cash flow after capital expenditure needs), that implies a 9% free-

cash-flow return on invested capital – and maybe 5% after fees and expenses. The rest of the

return that’s hoped for must come from doing other things: leveraging up the equity at a cost

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