In a speech to the Financial Planning Association, legendary Vanguard Founder and former CEO John Bogle made an observation that's absolutely critical to understanding where the best stock returns come from -- and how to find the next great stock to buy.
He told the assembled guests that only three things drive investor returns:
- Earnings growth.
- Changes in valuation.
That's all it comes down to. Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks to buy are the ones that will produce the highest combined return.
So which diversified financial stocks will earn investors the best returns today? Obviously, no one can say with total certainty. Estimates about the future should always be taken with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings per share estimates tend to be off by some 40%, so I've reduced their estimates accordingly.
But investing is all about making predictions based on imperfect knowledge of the future. So long as we're aware of the need to think critically about a company's prospects and to build a margin of safety into our stock purchases, analyst estimates can be a helpful tool for generating ideas. In this series, I run the numbers to round up the stocks that represent their implied best buys today. Here are our assumptions.
Dividend Yield (Current)
5-Year Growth Rate (Reduced by 40%)
Price-to-Earnings Ratio (in 2016)
|Kohlberg Kravis Roberts||3%||9%||18|
Main Street Capital
|Encore Capital Group||0%||9%||18|
Source: S&P Capital IQ. Includes stocks on major U.S. exchanges capitalized over $200 million with positive earnings and at least one analyst long-term earnings estimate.
And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.
Earnings Growth Return
Implied Cumulative Annual Return
|Kohlberg Kravis Roberts||3%||9%||19%||31%|
|Main Street Capital||8%||4%||12%||24%|
|Encore Capital Group||0%||9%||11%||20%|
Source: author's calculations.
*Assumes dividend growth at rate of earnings growth.
The raw numbers tell us that these are the 15 most promising names in diversified financials. Of course, analysts' growth assumptions for any individual company could prove overly optimistic or pessimistic, as could their future valuations, so the implied cumulative returns are hypothetical. That said, this list helps you focus on this sector's highest potential returners -- and provides an excellent starting point of names for further research.