Every investor out there is chasing market-beating returns. For a lot of folks, that means average returns of 10%. Mind you, this isn't as easy as it sounds, even if 10% is often cited as the S&P's average return over long periods of time.
That's why my eyes opened wide this week when I read a recent Fortune magazine interview with Warren Buffett. In it, the master investor insisted that he still believes the market will return less than 10% per year over the next seven years. In the same interview, Bill Gates, his buddy and Microsoft
The statement itself isn't a huge shock. Buffett made a similar prediction almost six years ago in the same publication, writing that he believed the market would return about 6% per year over the next decade, before inflation. If you include inflation in your returns, however, you'll want to allow for about 2% on average, so roll that return back to 4%.
Why the slow growth?
Before we delve into the causes of the slowdown in stock price growth -- not necessarily profit growth -- it's important to note that just halfway into Buffett's prediction, it looks like he was wrong. The market hasn't returned an average of 6%, or even 4%. In fact, it hasn't returned anything. Since his article was published on Nov. 22, 1999, the S&P 500 has delivered a 17% loss (1,420 in 1999 vs. 1,178 now). Though there are more than four years left, it looks like he was being generous six years ago.
The likelihood of rising interest rates is the main reason for lower market returns. As the rate of return on risk-free investments like government bonds rise, stock prices fall. That's because investors need to be compensated for taking on excess risk. Rates initially took a cut after Buffett wrote his article, but they've been on the increase lately, and it's likely that rising -- not falling -- rates will be more prevalent in the future.
The other reason for diminished returns has to do with investor psychology. Quite simply, investors -- or if you prefer, speculators -- had pushed stock prices to unreasonable highs and pushed up indexes like the S&P 500 to unsustainable levels as well. According to Barra, since 1999 the S&P 500 has fallen from a price-to-earnings multiple in the 30s back to about 18. That's a large fall, but an argument can be made that the recent performances of Google
Where can investors go for returns?
In Buffett's original article, he mentioned a couple of ways for investors to boost their returns and potentially beat the averages, but both methods require a fair amount of patience. The first is a standard piece of Buffett wisdom: Buy businesses with moats (long-term competitive advantages) at reasonable prices. Pepsi
The other way for investors to boost their returns is by focusing on companies that pay dividends. The dividends, however, must be material enough to make a difference in the total return. So, while Applebee's
However, such beaten-up banks as Wachovia
Foolish final thoughts
While dividends come second on the way to reliable and greater returns, it's no coincidence that businesses with moats often pay out healthy dividends. Moats allow dividend payers to generate the large levels of free cash flow, a necessary precursor to a rising dividend that you can count on.
Motley Fool Income Investor selection Unilever is a great example. Its stable of brands -- including Country Crock, Dove, and Hellmann's -- make for great long-term cash flows, as shown by its 3.4% dividend yield and a total return of 7.4% over the last nine months vs. the S&P 500's total return of -2.1%. That recommendation has been good food for the newsletter's subscribers.
Buffett isn't the only one to have written about the potential for a dreary stock market in the years ahead. For a more in-depth look at market cycles and the headwinds facing the current market, take a look at Bull! by Maggie Mahar or Bull's Eye Investing by John Mauldin. Both are interesting reads.
Or to get started on finding more superior dividend payers with market-beating potential, take a 30-day free trial to Mathew Emmert's Income Investor newsletter. Since its inception in 2003, Mathew's picks have beaten the S&P 500 by nearly three percentage points. And if you try the newsletter now, you'll enjoy immediate access to Mathew's two latest recommendations, which were released yesterday at 4 p.m.
You can truly boost your returns by focusing on companies that generate lots of free cash and pay rising and reliable dividends.