Long-Term Wealth Preservation Should Consider Declining Company Lifespans

| About: SPDR S&P (SPY)

Summary

A study by Innosight in 2012 showed that the long-term average company tenure on the S&P 500 is declining at a rate of about 1% a year.

Shortened lifespan should rationally imply lower P/E multiples over time, although we have not seen this happen yet.

Long-term investors should consider the types of companies less likely to be made obsolete over the long term.

A cap weighted index is an active strategy that continually adjusts for company attrition.

The Innosight study

Lifespans of companies in the S&P 500 Index are shrinking:

  • 61-year tenure for average firm in 1958 narrowed to 25 years in 1980 - to 18 years now.
  • At current churn rate, 75% of the S&P 500 (NYSEARCA:SPY) will be replaced by 2027.

Our analysis

While the Innosight study was about warning corporate leaders to keep innovating or risk dying, we are more interested in the investment implications of the study. Simply, if the lifespan of your investment is shorter than it used to be, you should require a faster investment payback than before.

We did an analysis of an expected P/E ratio each year beginning in 1960 based upon a declining lifespan each year. We value a company like a depreciating asset with no residual value, using a lifespan of 30 years in 1960 and declining down to 18 in 2014. Using a variant of a valuation model we employ in our research (using discount and growth rates in place at the time), we generate a present value for a stream of earnings lasting for the life of the company, and dividing the Present Value by the earnings in Year 1, to derive a "lifespan adjusted P/E ratio." We also calculate the P/E ratio if we kept the lifespan constant at 30 years.

The following graph shows that lifespan adjusted P/E ratios should have declined from about 15 in the 1960s down to around 12 today to account for this attrition effect.

The red line shows the company lifespan, right hand scale, declining at 1% each year. The blue line shows what the P/E would be if lifespan were constant at 30 years throughout the study, the dark green line shows the 'Lifespan P/E," and light green trend line shows the trend of the lifespan P/E - slowly declining over time. The actual P/E is shown by the dashed line.

The takeaway

  • It appears that investors do not account for declining lifespans in valuing the S&P 500 index. What is often referred to as a "normal" P/E of 15, might be acceptable if the lifespan was not declining (blue line), but is no longer "normal" with declining lifespans.
  • As a long-term investor, you should consider the P/E ratio relative to the lifespan of the industry. For example, technology has a very high attrition rate, whereas consumer staple industries such as food and residential real estate are less likely to be innovated out of existence. In many instances, these staples sell at lower P/Es than the hot growth technology stocks, even though they will likely produce earnings for a much longer time. This could partly explain the fact that low volatility stocks have outperformed over the long term.
  • It is important to differentiate between buying individual stocks and buying the S&P index in this regard. One of the benefits of a cap weight index from a lifecycle perspective is that you benefit from the changing composition of the index over time; growing companies continually replace declining companies. While cap weighted index funds are generally considered as passive, it is nevertheless an active strategy (without the fees) of selling the losers and buying the winners. Truly passive buy and hold would be buying an individual stock, or basket of stocks, and holding the same stocks for 30 years. This is the most dangerous strategy in light of the lifecycle evidence. Kodak is the best example of what can go wrong. The fact that the cap weighted index naturally adjusts for the attrition factor, may partly explain why the actual P/E has not declined to 12. If the same constituents from 30 years ago were still in the index, the P/E would most likely be lower than it is today.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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