High-Flying Stock Returns

Cost of Capital: A Gut Check on High-Flying Stock Returns

Nearly every year, a handful of securities generate headlines for delivering eye-popping returns. A challenge for investors is determining what portion of that return is a one-off windfall and not something to expect going forward. Viewing expected returns through the lens of cost of capital may help benchmark what constitutes a reasonable expected return from the market.

Companies issue equity and debt, otherwise known as stocks and bonds, to raise capital for investing in and growing their business. The rate of return on capital invested in these securities depends on both the supply and demand. The return must be sufficiently high to entice investor demand but not so high as to discourage supply by the company, which could otherwise seek alternative sources of funding. The link between these forces means an investor’s expected return is the company’s expected cost of capital.

This framework may help stave off FOMO about an extraordinary return event. For example, the Magnificent 7 stocks grew by 76% in 2023. (1) Even if the concept of expected return is nebulous, does this seem like a reasonable cost of equity capital? How high would borrowing rates have to be for a business to issue stock at that expected return? If the Magnificent 7 companies can secure funding at a lower rate through other means, 76% is not their cost of capital, which means it is not an investor’s expected return.

We believe financial plans should focus on the expected return. You do not want to bank on the unexpected repeating. Long-term data is more informative than short-term returns in setting expectations for the future. Across a century of returns, the broad US market has gained about 10% annualized. (2) Academic research suggests that returns can be boosted even further by emphasizing stocks shown to have higher average returns than the market, such as those with smaller market caps, lower relative price, and higher profitability.

Rather than trying to guess which stocks might provide next year’s outsize returns or getting caught up in a cycle of fear and greed, we believe it is better to set reasonable long-term expectations to track progress toward your financial goals.

This post was written by Marlena Lee, PhD (Global Head of Investment Solutions of Dimensional Fund Advisors) and Wes Crill, PhD (Senior Investment Director and Vice President of Dimensional Fund Advisors). This article was also first distributed by Dimensional Fund Advisors. Shore Point Advisors adheres to a similar investing philosophy to the one that is implemented by Dimensional Fund Advisors, which is the reasoning for the reposting of this article. 

FOOTNOTES

(1) In USD. Magnificent 7 stocks include Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla. Named securities may be held in accounts managed by Dimensional. Magnificent 7 return based on monthly market-cap-weighted average returns. Data provided by Bloomberg and calculated by Dimensional.

(2) The S&P 500 Index had an annualized return of 10.3% from January 1926–December 2023.

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RISKS

Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.

DISCLAIMERS

This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.

Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.

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