What are the most attractive sectors for the long-term investor?

EPS (g) is the long-term expected real earnings growth, LT e(r) is the the long-term expected return, MOM is the 12-month price momentum in the sector, and P/E is the 12-month forward price-to-earnings ratio.

The long drought in energy

As our table with long-term returns shows, the energy sector’s high capital return yield is dragged down by low expected real growth rates for earnings. To see why take a look at the chart below. It measures revenue per share in USD over the past 10 years. Not exactly a growth venture. In fact, the annualised nominal growth has been -0.2%, but with inflation running at 2.7% annualised over the same period, the real revenue growth has been -2.9% annualised. This reflects a combination of stronger USD, weaker energy prices, and weak volume growth.

Long-term investors should understand that while the energy sector is attractive seen from a high dividend yield and lots of buyback of own shares, the expected real growth rate is expected to be negative. Electrification in the decades to come will likely not make things better. Quite the contrary. So why have energy in the portfolio at all? Because it is a defensive sector, and the sector that provides the most protection should inflation come back to bite.

How to estimate long-term expected returns?

Many retail investors are brought up to think that P/E ratios are the answer to everything. Whether something is expensive or not. It is not that simple. The way you build up your long-term expectations are by starting with the dividend yield. Next you add the buyback yield (which is the amount of shares the company buys back over the past year). Buybacks are another way (often tax efficient) to return capital to shareholders. The sum of the two is called the capital return yield. This is the long-term expected real return to shareholders under the assumption that a company or sector can grow earnings with inflation (so zero percent real growth). If a company or sector can grow faster than inflation the expected real earnings growth rate is added and you then have the long-term estimated return. We use historical real revenue growth as the future indicator for real earnings growth as this is more stable, but the underlying assumption is that the profit margin will not change much in the future.

The sum of these three factors (dividend yield, buyback yield, and real long-term earnings growth adds up the expected long-term return. As can be seen by the first table, health care has a better expected return compared to financials despite being valued at a significant P/E premium showing exactly the point that P/E ratio is not a good indicator for long-term returns.

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