Co-Authored by Michelle Kangas & Dr. Bryan Taylor
Warrant Buffett once said that the stock market capitalization to GDP Ratio (MC/GDP) is “probably the best measure of where valuations stand at any given moment.” Global Financial Data has decided to follow in Warren Buffett’s footsteps and has added data on the ratio of stock market capitalization to GDP for all the stock markets in the world. GFD has the most extensive historical data on stock market capitalization and GDP available anywhere. This enables us to provide data on Buffett’s favorite indicator going back centuries, not decades. MC/GDP data for the United States begins in 1792 and data for the United Kingdom begins in 1688.
There are several factors which influence the ratio of stock market capitalization to GDP. First, countries with more multinational companies have a higher ratio than countries without. The MC/GDP ratio is particularly high for Switzerland and Hong Kong because those countries have numerous multinationals listed on their exchanges. Switzerland’s MC/GDP ratio is over 200% and Hong Kong’s ratio is over 1000%. Second, interest rates influence the ratio. Bond yields provide an opportunity cost for investing in the stock market. The higher bond yields are, the lower will be the MC/GDP ratio. The lower bond yields are, the higher will be the ratio. Third, government ownership of major industries, banks and utilities reduces the MC/GDP ratio because these industries are publicly owned rather than privately owned. Fourth, industrialization of the economy increases the MC/GDP ratio and has generally increased over time. Fifth, whether a country relies more on markets or banks to direct capital to industry affects this ratio. Anglo-Saxon countries generally rely more on stock markets than continental European countries and tend to have a higher MC/GDP ratio. Sixth, wars tend to redirect capital to funding government bonds and increases regulation of industry. This tends to reduce the MC/GDP ratio. All of these factors should be taken into consideration when trying to analyze whether the MC/GDP ratio indicates that the stock market is overvalued or undervalued for any country.
GFD has created a simple mnemonic that enables subscribers to quickly find data for the country they are interest in. The ticker begins with “SC”, then adds the ISO code, then adds “MPC” at the end, so the symbol for the market cap of the United States as a share of GDP is SCUSAMPC and for Canada it is SCCANMPC.
There are many things that subscribers can do with this information. Figure 1 compares the stock market capitalization of the United States with the outstanding government debt as a share of GDP. Several of the factors mentioned above are clearly visible. The inverse correlation between war, stock market capitalization and debt is visible during World War I and World War II. The impact of rising interest rates in the 1970s and falling interest rates since 1981 have clearly impacted the MC/GDP ratio. Since 1980, both the debt/GDP and the MC/GDP ratios have risen. Over the past 50 years, the United States has deregulated many markets which has contributed to the increase in the MC/GDP ratio.
Figure 1. United States Government Debt and Stock Market Capitalization to GDP, 1792 to 2018
Global Financial Data provides data on the MC/GDP ratio for every major stock market in the world. GFD provides more history for this ratio than any other data vendor. The MC/GDP ratio in the United States is around 164% today. This is one of the highest ratios in history; however, bond yields are also at their lowest levels in history. Could the MC/GDP ratio be headed to 200% as in Switzerland, or does the high ratio portend a crash as occurred at previous peaks in 1999 and 2007? Time will tell.
The equity-risk premium (ERP) is one of the most important variables in finance. It tells investors how much a risky investment such as stocks returns relative to a risk-free investment such as government bonds. Any history of the equity premium shows that its value is not constant. It varies dramatically from one year to the next. In theory, riskier stocks should provide a higher return than risk-free government bonds, but unfortunately, this has not always been true.
I often crave donuts being the sugar lover that I am. And I am not alone here at Global Financial Data. On the way to the office there is a local Donut shop called Rose Donuts & Cafe, which has the best donuts as is depicted in Figure 1 — fluffy, fresh, overly large delights such as maple bars, cake donuts, sprinkles, chocolate glazed, old fashioned, Bavarian crème filled goodies, and cinnamon rolls so large you could quarter them and still be stuffed. So many flavors to choose from, French-croissants and fresh baked muffins.
So, I ask myself why is there still a Dunkin’ Donuts, across the street when Rose’s donuts taste so much better? I had to find out who owns the Dunkin chain because it must have some story behind it because they certainly don’t have good tasting donuts in my opinion. And quite a story there is.
Dunkin’ Donuts, Figure 2, as it is known today, was founded by William Rosenberg, a Jewish immigrant, who only completed the eighth grade. He was quickly forced to work at the age of 14 to help support his family when his father Nathan lost the family grocery store during the great depression and held many jobs during his teen years. After working for Western Union, as a full-time telegram delivery boy, Rosenberg began working for Simco, a company that distributed ice cream from refrigerated trucks. At Simco, he quickly rose through the company and by age 21, he was a manager supervising their production and manufacturing of nearly 100 trucks.
Through his observation of human purchasing behavior over the course of his many jobs in the service industry, Rosenberg gained the knowledge necessary to start his own donut shop. However, Rosenberg did more than just that. He started an entire franchise and even adjusting for inflation – he did it with very little cash in 1940s.
After World War II, Rosenberg borrowed $1,000 and combined this with $1,500 (roughly $25,000 today) he had in war bonds to start his mobile catering service “Industrial Lunch Services” that delivered meals and offered coffee break services to factory workers outside of Boston, Massachusetts.
Rosenberg designed his own catering vehicle, as seen in Figure 3, that had custom-built stainless steel shelves that stocked snacks and sandwiches which were basically a prototype for the current mobile catering vans still used today. Rosenberg’s focus was on making the customer happy through options and choice as his trucks clearly displayed the items for customers to make their own selection. Shortly, thereafter, Rosenberg had over 200 catering trucks, 25 in-plant outlets and a vending operation that delivered food to factory workers. Through continued observation, while serving food at construction sites and factories, where that donuts and coffee were the top picks of the daily visitors who were often in a hurry, Rosenberg’s knowledge grew as he continued to study the human experience.
Shortly thereafter, he decided to open a store that specialized in coffee and donuts after he determined that 40% of his revenues came from coffee and donuts and wanted to offer 52 varieties of donuts since traditional donut shops offered only five different varieties. On Memorial Day in 1948 in Quincy, Massachusetts, Rosenberg founded Open Kettle Donuts, changed its name to Kettle Donuts, and then to Dunkin’ Donuts in 1950.
Early on Rosenberg began laying an excellent foundation of marketing concepts for Dunkin’ Donuts beginning with an ideal name for his business combining the coffee and donuts theme from his previous personal experience. He laid the foundation for the brand even before it began through his keen sense of human need and Rosenberg coined the phrase “The Customer is Boss.” His initial brand foundation was off to a great start and within five years, others began expressing a franchise interest. Rosenberg continued to grow the franchise chain to 100 locations in 1963, when he turned the day to day operations over to his son.
In 1990, with more 1000 stores, British beverage conglomerate, Allied Domecq purchased the thriving Dunkin’ Brands fast food restaurant chain. Figure 4 shows the performance of Dunkin’ Donuts between 1968 and 1990 when the company was bought out at $43.75 per share. The company underperformed the S&P 500 in the 1970s, but during the 1980s, it hit its stride and the stock price rose dramatically. The company had stock splits in 1981, 1983 and 1985. The company’s revenues more than doubled and the stock price rose over tenfold. You can see why Allied Domecq felt they had made a good investment. I have also included the fundamentals for your review. These can be seen in Figure 5.
FUNDAMENTALS OF DUNKIN’ DONUTS 1968-1989
|Date||Net Sales ($ Million)||Shareholder’s Equity||Price To Sales||Price To Cash Flow|
Figure 5. Dunkin’ Donuts Fundamentals, 1968 to 1989
Fifteen years later, in July 2005, Allied Domecq was acquired by their parent company, Pernod Ricard SA. Pernod knew quickly that they needed to alleviate debt, so the French beverage company began searching for a buyer for this segment of their product line.
In December 2005, Pernod Ricard SA, sold Dunkin’ Brands, to three private equity groups: Thomas H. Lee Partners, the Carlyle Group and Bain Capital for $2.43 billion. Thomas H. Lee, Carlyle Group and Bain all had vast fast food experience. Each had an equal share in Dunkin’, each desired to be partners, and each wanted to work with the existing Dunkin’ management team and CEO Ron Luther. Their combined goal was to take the chain to the next level. Their plans were aggressive seeking expansion to the west, to offer additional franchises, branch into more coffee beverages, offer higher-end, glamorous coffee drinks that would compete with Starbucks. The results are can be seen in Figure 6.
Five years later with a thriving business, T.H Lee, Carlyle Group, and Bain Capital applied for an I.P.O. and the company went public in 2011. The company had 97 million shares outstanding making the company worth $2.7 billion when it IPO’d on July 27, 2011, providing the three private equity groups, each with a 10% return, over their cost of buying the company in 2005.
During the past eight years, as Figure 7 shows, Dunkin’ Brands has outperformed the S&P 500. The company is now worth over $6.5 billion, providing a 13% annual return to anyone who invested in the IPO in 2011. Today DNKN trades on the Nasdaq and consistently shows rising sales, profits and the number of its locations. Due to Rosenberg’s brilliant observations and his ability to respond to consumer needs, he was able to build his business.
Dunkin’ Brands currently includes the Dunkin’ Donuts chain, Baskin-Robbins ice cream parlors and Togo’s sandwich stores. In the United States and the rest of the world, the growth of Dunkin’ Donuts has been strong. Today, Dunkin’ Donuts offers a mind-boggling mix of over 15,000 varieties of coffee. This includes Turbo Shots, Espresso, Iced Coffee, sugar free, with or without cream, low-calorie options, and dozens of other variations of the world’s favorite beverage, coffee! Some of the flavors you can get include Butter Pecan Swirl, Caramel, Cookie Dough, White Chocolate Raspberry and Rocky Road swirl.
I hadn’t even heard of all these flavors of coffee before. Had you? I think that I’m going to check out Dunkin’ Donuts later this week.
On December 9, Paul Volcker, who served as Chairman of the Federal Reserve Bank from 1979 to 1987, died at the age of 92. Paul Volcker changed the shape of the economy and of financial markets.
The Rise and Fall of Interest Rates
Paul Volcker is known for two things. He instituted the Volcker Rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This prohibited banks from conducting some investment activities with their own accounts and limited their dealings with hedge funds and private equity funds.
Figure 1. USA 10-year Government Bond Yield, 1940 to 2019
Figure 2. United States Inflation Rate, 1950 to 2019
Second, Paul Volcker defeated the rising inflation and interest rates of the 1970s. In 1981, the yield on the 10-year bond peaked at 15.84% as can be seen in Figure 1. Today, the bond yield and inflation are both below 2% as depicted in Figures 1 and 2. Government bond yields in most of the Euro zone are negative in nominal terms and are negative in real terms in the United States. There is no sign that bond yields, interest rates or inflation will reverse and begin rising in the near future. If anything, bond yields are likely to continue to decline in the United States.
Paul Volcker Reverses 40 Years of Rising Rates
Paul Volcker instituted major changes that impacted investors. Between 1792 and 1941, stocks provided a 6.80% return while bonds provided a 4.99% return. Then the great Keynesian inflation began. Between 1941 and 1981, US equities returned 11.38% while the 10-year bond returned only 2.75% as can be seen in Figure 3. Inflation averaged 4.60% during those 40 years meaning that after inflation bond investors actually lost money as is illustrated in Figure 4.
Figure 3. S&P 500 Composite Total Return and Government Bond Total Returns, 1940 to 2019
However, between 1981 and 2018, stocks returned 11.13% and bonds returned 8.04%. This is illustrated in Figure 4. Bonds made no progress from 1940 to 1981, then provided dramatic returns from 1981 to 2019. The cause of this change was Paul Volcker. Although there was little difference in the annual return to equities, the return to bonds rose significantly as the decline in bond yields produced capital gains rewarding bond investors.
Figure 4. United States Government Bond Return Index and Consumer Prices, 1941 to 1987
The years between 1941 and 1981 were atypical of American financial history. The equity risk premium rose from 1.72% between 1792 to 1941 to 8.40% between 1941 and 1981. As equity markets recovered after World War II, bond investors were punished with rising bond yields, and many investors falsely interpreted the high returns as the standard for the equity risk premium.
Figure 5. U.S. Government Bond Returns Adjusted for Inflation, 1940 to 2019
The Death of the Equity Risk Premium
Investors began to expect high returns on stocks; however, between 1981 and 2018, the equity risk premium fell back to 2.75%. This is illustrated in Figure 6. In some countries, such as Canada, government bonds have beaten the stock market since 1981. Most people believe that the equity risk premium is around 6% or even more when historically, except for the period between 1941 and 1981, the equity risk premium has been around 3%. Although bond yields may still decline in the next few years, the room for decline is minimal.