John C Bogle, the founder of Vanguard is becoming one my my favorite speakers on financial markets. His speeches are really thought provoking and gives many simple ideas. His speeches are available on his blog.
I just read this excellent speech where he revisits various concepts of finance. He discusses valuation really well:
By the late 1980s, based my own first-hand experience and my research on the financial markets, I concluded that the two essential sources of equity returns were: (1) economics, and (2) emotions. What Keynes had described as enterprise I called “economics.” What Keynes termed “speculation,” I found well-defined by “emotions.” The former I defined as investment return— the initial dividend yield on stocks plus the subsequent annual rate of earnings growth. The latter I defined as speculative return—the change in the price investors are willing to pay for each dollar of earnings.
Simply adding speculative return to investment return produces the total return generated by the stock market. For example, if stocks begin a decade with a dividend yield of 4 percent and experience subsequent earnings growth of 5 percent, the investment return would be 9 percent. If the price-earnings ratio rises from fifteen times to twenty times, that 33 percent increase, spread over a decade, would translate into an additional speculative return of about 3 percent annually. Simply adding the two returns together, the total return on stocks would come to 12 percent. It’s not very complicated!
He then shows most returns in US equities has come from economics and not emotions.
He goes on to dicsuss the excesses in financial industry:
I’ve written a book about these issues,8 and I express my conclusion bluntly. Using words remarkably close to those of Minsky, I describe how capitalism has changed for the worse. In a half century we’ve moved from an ownership society where individual shareholders owned 92 percent of all stocks and financial institutions owned only 8 percent to an agency society in which institutional shareholders now own 74 percent of all stocks.
But we haven’t changed the rules. These mutual fund and pension fund managers have largely ignored the interests of their principals—fund shareholders and pension beneficiaries. To restore balance to the system, we need a new fiduciary society in which the interests of these 100 million principals—the last-line investors of America—come first.
This one takes the cake:
In any event, we’re moving, or so it seems, toward becoming a country where we’re no longer making anything. We’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune. We’re also adding even more costs by creating ever more complex financial derivatives in which huge and unfathomable risks have been built into our financial system.
He shows how financial system has added more costs over the years implying it benefits them more than anyone else.
This is an excellent speech from someone who has stood his ground and has believed in selling low cost funds.