100 Ways to Beat the Market #17: Select securities with a higher expected return than the market

If you want to beat the market, you need to have a clear understanding of what drives market returns. Generally speaking, you can expect the returns of the the S&P 500 to be closely correlated with the growth of corporate earnings. Corporate earnings in turn are closely tied to GDP growth. After all, per Buffett, you can’t expect a component part – corporate earnings – to indefinitely grow at a faster rate than the aggregate to which they belong – the overall economy.

You can provide your own estimates, but assuming that real GDP growth averages 3% and that inflation is at 3%, your would get a 6% return. Add in 1.5% for dividends and you are 7.5%. If you are expecting more than this, then you need to provide and defend your assumptions.

Is the market’s return on equity closer to the high end or the low end of its historic average? Are multiples of earnings high of low? What are your expectations for interest rates going forward? These all play a roll in setting expectations.

What is the point of this exercise if you are trying to best the market?

In sports, top athletes carefully study their opponents so they can get an edge. If you clearly understand what drives overall stock market performance, you can make a rule for yourself that you will only buy securities that offer superior expected returns both as a function of the businesses’ underlying economics and also the price you are paying for their securities.

If you buy better businesses at better prices, you will beat the market.

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