Charlie Munger's Equity Forecast For The Next Decade

It's no secret that when the stock market is expensive, 10 year returns after buying aren't great. In a recent Q&A Munger stated that real returns over the next decade will be low.

Why?

He listed a number of reasons that are all very valid: tons of new investors entering the market, frenzied purchasing of equities, management incentives that reduce earnings, low-interest rates. If you want to watch the full interview check it out below:

If you've researched markets at all, you've probably come up with the Shiller PE ratio, also called the Cyclically adjusted price-to-earnings ratio which is an average of ten-year inflation-adjusted earnings. Basically, the CAPE smoothes the line out rather than deep peaks and valleys. As the graph shows below, when the CAPE is high, returns over 10 years are clearly reduced vs. when the CAPE is low.

As you can see, it doesn't really matter what country you're looking at, when the CAPE is high, average real returns are low. Where is the CAPE now? According to the World Population Preview:

Below is the CAPE ratio for the largest economies in the world as of June 30, 2020:

• Canada 21.67

• The United States 29.35

• The United Kingdom 13.22

• Italy 18.71

• Spain 12.36

• Russia 8.21

• India 23.29

• Japan 19.00

• China 15.82

• Hong Kong 12.70

• Australia 15.70

So yes, there are always opportunities to buy great businesses as you can see from countries like Russia. Now let's get back to Munger!

Since the pandemic broke out in North America a multitude of new retail investors have entered the market. Here what I've witnessed by reading and talking to some of my friends who have started to invest:

- They don't use traditional multiples to evaluate companies. Many forego PE and instead look exclusively at revenues (not the best metric to use especially when you're regularly seeing companies trading at 100x revenues)

- They're not worried about the future. Things are getting better, but who knows what rate things will improve at. There are many newer tech stocks that have sky-high valuations that are nearly impossible to predict in the future. I'm looking for certainty, the market seems to give zero f&*ks about certainty.

- People are buying based on prior performance. They see something like Tesla, or _______ (insert any other tech name) that has gone up 500% and think that's a good equity to invest in (hint: it's not)

- People aren't worried about the downside and what can happen given a correction. More expensive stocks will get crushed, stocks that are already cheaper can also get crushed, but tend to "get crushed" to a lesser extent.

Add to that the preponderance of SPAC's and IPO's and you're looking at serious bubble territory. SPAC's and IPO's are released into the market when the owners of these businesses know they can get huge valuations. They know they can get that now, and therefore now is a great time to let the market print money for their equity.

Lastly Munger discusses poor management incentives and low-interest rates. Put simply many boards of large corporations don't operate the companies they serve with the shareholders in mind. They're often cronies of the CEO and will issue options to their executives and employees which allows them to "pay" their employees without incurring costs on their income statement.

Unfortunately, this comes at a great cost to owners of their stock. These options are offered below market value and also dilute shareholders by adding more shares to the "pool." This is not what I'm looking for, but it's nearly impossible to avoid when looking at great opportunities. For instance, let's say you have 100 shares priced at $ each in a company with a market cap of $1000. 100 options are issued to management at $.5. Before you owned 10% of the company 100 shares * $1 = $100. 100/1000 = .1 or 10%. Now that these options are issued, there are now 1100 shares that fit into the same market cap of $1000. So your ownership percentage drops from 10% to 100/1100 = 9%.

This is something to look out for. I'm still learning more about this area and seeing how great owner-friendly businesses compensate their management and employees that don't dilute shares. One thing to look for during these low-interest rate times is if companies are raising debt by issuing equity, or by getting a loan. Given how low-interest rates are now, issuing equity for debt seems like a poor choice.

Lastly, Munger discusses interest rates. With the risk-free rate (Treasury bond rates) being less than 1%, there isn't much of a reason for investors to invest in Bonds. So instead of buying bonds, this money is flooding equity markets as it's not very hard to beat 1% returns with equities. Therefore money is flowing into equities causing multiples to expand.

Circling back to the start of this post, when multiples (in this case CAPE) goes up, real returns for the next decade go down. In the US the CAPE is currently above 33. As the chart shows, this provides incredibly low returns over the next decade ~0-1%.

So what am I doing?

Accumulating cash and waiting for opportunities in new ideas I find, or adding to my current holdings on large pullbacks. It's hard to find good ideas out there now with prices being so high, but you don't need a lot of ideas to generate good returns. Mohnish Pabrai says on average he gets a new idea every 1-3 years, and he's done incredibly well. The pickier you are, the more patient you should be, and therefore can have lots of dry powder to deploy when a can't miss idea comes up!

Good luck out there!