What drives stock prices? It may surprise you

John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds.

Back on July 22, Morgan Stanley announced dreadful second-quarter 2009 results. Earnings per share were negative for the fourth straight quarter, and revenues were less than half of what they were a year earlier.

That same day, Apple posted glowing second-quarter results, with earnings jumping more than 60 per cent and revenue rising almost 30 per cent. In part because of those strong figures, Apple's stock went on to return 30.9 per cent in the next three months, about double the broader market's gains.

And Morgan Stanley? Despite the losses and revenue plunge, it gained a nearly identical 29.8 per cent over that same span.

The strong gains from two firms whose businesses were posting very different results is a great example of how a multitude of factors drive stock prices. In the short term, that makes it very difficult to predict the movements of a particular stock, or the market as a whole.

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But what about over the longer term? What factors really drive equity prices over the long haul? And, perhaps most importantly, can we quantify them?

A new study from MSCI Barra, entitled "What Drives Long-Term Equity Returns?", attempts to do just that - and its findings might surprise you.

Barra (whose market indices are widely used by investors around the world) studied equity returns over the past 35 years in a variety of markets, and broke down those returns into several components. The major ones: inflation; real book value growth (i.e., how much the company's underlying business and assets grow); price-to-book growth (how the amount of money investors are willing to pay for every dollar of that book value changes over time); and dividend income.

The results: According to Barra, the most significant of those components is inflation, which accounted for 4.2 percentage points of the MSCI World Index's 11.1-per-cent return from the start of 1975 through Sept. 30, 2009. The second biggest factor: dividend income, which accounted for 2.9 percentage points. Real book value growth and price-to-book growth accounted for 2.1 and 1.5 percentage points, respectively. The results were similar for many of the markets within that world index, including the U.S.

What that indicates is that over the long run, about two-thirds of the stock market's returns are the result of inflation and dividend payments - two un-sexy factors to which many stock investors don't give enough thought.

I talked about the impact of inflation on equities in my Sept. 8, 2009, article "Ask Buffett: If inflation comes, stocks are best bet." In that piece, I referenced the extensive research Canada-born investment guru David Dreman has done on the topic. Mr. Dreman, whose writings are the basis for one of my Guru Strategy computer models, has called inflation a "virus" that permanently entered the investment world after the Second World War. He found that over the long term, inflation eats away at the return of fixed-income investments like bonds or Treasury bills. Stocks, however, can draw on increasing earnings streams as companies raise prices and increase profits to keep up with inflation. Inflation is thus, to some extent, built into the companies' bottom lines, and, in turn, into stock prices as well.

As for dividend income, the implications are clear: While most investors today focus on stock price appreciation, good ol' dividend yield shouldn't be ignored in any market environment.

In the current equity market, inflation and dividend yield would seem to be particularly important for investors. Given the huge stimulus programs put in place around the world, many top strategists (including Mr. Dreman and Warren Buffett) have predicted that a period of high inflation is coming. And, given the major run-up in prices during the recent stock rally, strong yields are growing tougher to come by - currently only about 90 stocks in the market get approval from my Guru Strategies and yield 3 per cent or more. With that in mind, here are a few of the high-yielders that do get approval from my models, and which come from industries that would figure to fare well in an inflationary climate.

KRAFT FOODS INC.

This big Warren Buffett holding has made a lot of headlines lately for its Cadbury takeover, but my James O'Shaughnessy-based model is more concerned with the Illinois-based food giant's fundamentals. It likes Kraft's $2.23 (U.S.) in cash flow per share (more than four times the market mean), high sales (more than $40-billion over the past year), and impressive 4.1-per-cent yield.

UGI CORP.

This propane, butane, natural gas and electricity utility has upped its dividend in each of the past 22 years, and currently yields about 3.2 per cent. The model I base on the writings of hedge fund guru Joel Greenblatt is very high on the $2.7-billion-market-cap, Pennsylvania-based firm, thanks to UGI's impressive 53.3-per-cent return on total capital and sparkling 37.6-per-cent earnings yield.

CHEVRON CORP.

The California-based energy behemoth, which is currently yielding about 3.7 per cent, is another favourite of my O'Shaughnessy-based value model. The strategy likes the firm's size ($148-billion market cap), strong yield, and $11.91 in cash flow per share.

(Disclosure: I'm long Apple, Kraft and Chevron.)