Since 2009, stock prices are up well over 100%. The stock market has moved higher for a variety of reasons - including an economy that has improved dramatically from the Great Recession and continued stimulus from the Federal Reserve to keep interest rates low (read our post on the economy and interest rates here).
The primary driver for growing prices has been improving fundamental values. Long-term stock market appreciation cannot exist without increasing dividends and earnings. As we have said many times, dividends have shown to be highly correlated with stock prices over the long-term. Since dividends are real cash paid out to shareholders, they ultimately must be backed by actual corporate earnings.
With the U.S. economy expected to continue its sub-optimal growth in the face of continuing political and fiscal headwinds, some are questioning whether or not businesses will continue to be able to increase profits the way they have over the past several years. Without much economic growth in the United States, how can there be sustainable long-term earnings and dividend growth?
Earnings and dividends growth for the stock market as a whole have historically been correlated with GDP growth. Over the past decade, we have seen a disconnect between U.S. earnings growth and GDP.
The chart above shows real earnings growth (inflation taken out) for the S&P 500 compared to real GDP for the past 30 years. Between 1983 and 2000, earnings and GDP tracked together closely. Real GDP growth for the period was 3.8% compared to 4.3% earnings growth. During the past 10 years, however, earnings growth (3.8%) has been more than twice as high as GDP growth (1.6%).
Earnings have outpaced U.S. GDP growth for a couple of reasons. (1) Companies have become very efficient. Those who survived the 2008-09 recession have become leaner and more productive than ever before. (2) As the U.S. economy has slowed, corporations have looked for new markets to do business in. They have found those markets in Europe, Asia and the Far East.
According to S&P research, nearly 48% of the total sales by S&P 500 companies in 2013 have come outside of the United States. That's up from under 42% just 10 years ago. Lower labor costs and other expenses have made it even more attractive from a profitability standpoint.
Very large, multinational companies have expanded their overseas businesses at even faster rates than in the United States. The Coca-Cola Company (NYSE:KO) has become an increasingly global company, which has been very profitable. Nearly 80% of total operating income for the world's largest soft-drink manufacturer now comes from countries outside the U.S. Procter & Gamble (NYSE:PG) generates nearly the same amount of revenues from Western Europe and Asia as they do from the United States. In total, over 60% of PG's 2013 revenues come from non-U.S. markets - up from less than 45% in 2002. Johnson & Johnson (NYSE:JNJ), another multinational giant, has grown revenues from $36.30B in 2002 to $67.22B in 2012. Over 75% of that revenue growth came from outside the U.S.
As the value of the dollar has dropped over the past several years, the competitiveness of products produced by U.S. companies has gone up. Companies are more exposed now than ever before to international markets. Even with sluggish growth continuing in the U.S., very large, multinational companies can continue to produce earnings growth for many years to come.
While we expect companies to grow earnings much faster than the U.S. economy seems to suggest, we expect dividend growth to be even better. Payout ratios (dividends / earnings) are near historic lows. With investors placing more value on the dividend, we expect companies will increase their payout ratio to more normal levels. As dividends continue to grow, investors are increasingly turning to dividend-paying companies growing income in an environment where there is very little opportunity in the fixed income market.
Disclaimer: Donaldson Capital Management employees and clients own shares of KO, PG and JNJ.