Early in the year–way back in the pre-pandemic days of January and early February–I read William Bernstein’s “The Four Pillars of Investing.” This book was a lively, well-written, and enjoyable read. I got much great investing insight from it, and envisioned writing a blog post about it. With the recent market crash–where prices dropped 30% from recent highs–I find that Bernstein’s ideas are uncannily well-timed. I shall focus here on his section on the Dividend Discount Model.
The Discount Dividend Model, as Bernstein explains, “allows the investor to easily estimate the expected returns of stocks and bonds with far more accuracy than the study of historical returns” (p43). This blog post is not about the model, (from here on out to be referred to as “DDM”), because, frankly I don’t understand the mathematics of it fully! However, the ideas and insight that accompany Bernstein’s discussion are pretty phenomenal.
Here are few quotes I found especially interesting, as well as some of my own thoughts:
A stock or bond is not an abstract piece of paper that has a randomly fluctuating value; it is a claim on real future income and assets.“The Four Pillars of Investing,” p54.
I like this because it helps re-frame the idea of owning stocks and bonds. We aren’t just holding something and hoping it goes up in value. We are holding something with the expectation of a lifetime of future income!
The fundamental return of the stock market–the sum of dividends and dividend growth–is somewhat predictable, but only in the very long term [30+ years].”“The Four Pillars of Investing, p58.
Here, Bernstein is referring to how the DDM seems to predict future stock market returns over the very long-term with a fair degree of accuracy. This has to do with the the Gordon Equation, which is a sort of corollary of the DDM. The Gordan Equation looks like this:
Market Return = Dividend Yield + Dividend Growth
If this is Greek to you, I’m with you. But basically, the equation shows that if you look at the dividends stocks offer–not merely their current price–you can use this to extrapolate a long-term expected return. I find the idea fascinating, even if the mechanics are still a bit obscure and mysterious.
The most sustainable way to get high stock returns is to have a dramatic fall in stock prices. Famed money manager Charles Ellis likes to tease his friend…which market scenario would they rather see…stocks rising dramatically and then staying permanently at that high level, or falling dramatically and staying permanently at that level. The correct answer is the latter, since with permanently low prices you will benefit from permanently high dividends…
After several decades, the fact that you are reinvesting income at a much higher dividend rate will more than make up the damage from the original price fall. To benefit from this effect, you have to be investing for long enough. Typically more than 30 to 50 years…
After an 80% fall in prices, the higher long-term return eventually compensates for the devastation.“The Four Pillars of Investing,” p61
To me, this starts to get at the most interesting part of the whole chapter. Bernstein argues that stocks have their highest expected return when they fall dramatically in price. Part of this has to do with how as the price drops, the dividend yield rises, which, as he says, “makes up the damage from the original price fall.” In fact, in this section Bernstein claims that an 80% stock market collapse would actually have a quicker recovery than a 50% drop. This is because the dividend yield after such a steep price drop would be a lot higher than for the less dramatic drop. Therefore, the expected return would be a lot higher as well. Pardon me if this seems a bit heady, but the point is, if prices dropped by 80%, there would be this a massive silver lining in the increased dividend yield!
[A] young person saving for retirement should get down on his knees and pray for a market crash, so that he can purchase his nest egg at fire sale prices.“The Four Pillars of Investing,” 63
This is perhaps the most viscerally-impactful line in Bernstein’s entire book. I still recall writing down this quote a little over two months ago. I thought to myself, “Wow… we’ve been in this bull market for 11 years. When would a market crash like that happen?” Little did I know how quickly!
Had you the nerve to buy stocks in June of 1932 and hold on until 1960, you’d have earned an annualized return of 15.86%, turning each dollar into $58.05. Few did.“The Four Pillars of Investing,” 65
This further supports Bernstein’s suggestion that the most dramatic market drops yield the biggest long-term returns. It also notes an aspect of human behavior that is often mentioned in investing books: most people–whether because of lack of investing fortitude, lack of investing knowledge, or bad luck–do not take full advantage of the best market opportunities.
Although today’s post amounts essentially to “Show and Tell” of a book that I especially enjoyed, I hope that readers can see how these ideas relate to our present market downturn. I had no idea when I read this book back in January that we would be where we are now! Ultimately, Bernstein’s ideas are a reminder that a market drop can bring great benefits for those who are prepared to receive them.
In the immortal words of Napoleon Hill in his book “Think and Grow Rich”:
“Within every adversity is an equal or greater benefit. Within every problem is an opportunity. Even in the knocks of life, we can find great gifts.”