There has long been a debate about which asset class is the best to own. The discussion around property vs equities is particularly interesting. But in my opinion, there should be no discussion for long term investors as equities (stocks) are the best hands down. Looking at historic returns, equities have historically outperformed all other asset classes returning 9% per annum whereas property only returned 5.7% per annum. So why do equities outperform all other asset classes?
The main reason why equities produce higher returns is due to equities having the unique ability to compound in value in a way that investments in other asset classes cannot. The explanation for this is simple: companies retain a portion of the profits they generate to reinvest in the business.
When you look at a company’s finances, you will find that many of them only pay out a portion of their earnings in dividends. The earnings that are not paid out are invested in the business to produce even more earnings. It is a compounded vicious loop of wealth creation.
No other asset class provides this automatic reinvestment. Taking property as an example, the owner will receive rental income but none of it will be reinvested into the property for them.
The value that reinvestments have on equities should not be underestimated. It is a huge source of compounding. To demonstrate this, say you owned the average company in the S&P 500 which earned a return on equity capital employed of 13 per cent last year. If it can retain half the earnings which are attributable to you as an investor – i.e. has a dividend payout ratio of 50% – and it can continue to invest at its current rate of return as its business grows, that half should also earn 13 per cent.
What makes the above example even more interesting and return friendly is that the average company on the S&P 500 trades on 3 times book value. So for every $1 of earnings the average company retains, a $3 increase in market value occurs.
From the above you can certainly see why Equities trump all other asset classes and produce average returns of 9%.Whilst this average return is juicy, you can further stretch it by owning great companies. Again the logic is simple. Instead of owning the index – which is made of a bunch of companies – and seeing the companies reinvest your retained earnings at an average rate of return, you own only companies which can achieve a high return on capital and which can as a result manage to translate each $1 of retained earnings into a market value which is a much higher multiple of book value. Owning the best companies who will efficiently allocate your capital will certainly compound your money at a higher rate.