Let's cut right to the chase: Our research suggests that SPDRs Trust (SPY), an ETF that tracks the S&P 500 Index, will return 14% annualized over the next three years.
Lest you wonder which hat we pulled that number out of, rest assured that there were no wands or seers involved. And because top-down macro forecasting isn't our bag (what…you were expecting the second coming of Bill Gross?), we kept the focus squarely on the stocks in front of us.
As it turns out, that's a lot of stocks--we cover 2,000 companies, including more than 450 of the S&P 500's constituent holdings. Therefore, we can harness the work that our analysts do in evaluating company fundamentals, such as the presence and durability of competitive advantages each business might boast. That work culminates in a fair value estimate that our analysts place on each stock they cover. We can roll up the fair value estimates that our analysts have placed on the S&P 500's holdings and, voilà!, come up with a fair value estimate for the index as a whole (1,626.80 as of Nov. 7).
But how does that get us to an expected return? We ordinarily expect a stock's price to converge to fair value over a three-year time horizon. Assuming that we compound our fair value estimate at the cost of equity--which is the minimum compensation that we demand for owning a stock--the expected return represents the return that will cause the stock's price to converge to fair value at some point in the future, not to exceed three years.
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