Issue: Oct 2010/Jan 2011
Back to Basics 4

History lessons

Bernard Fick

Fick...confident expectations

If we’ve learned anything about equity returns – comprising earnings growth, re-ratings and dividends – it’s that they’ll beat inflation. Bernard Fick, chief executive of Prudential Portfolio Managers, looks back on a century to look ahead for the next three to five years.

Investors now have access to about 110 years of SA stockmarket data. This history helps us set expectations about long-run equilibrium returns (which do not make any assumptions about the current level of the equity market) and helps us develop a transitional-return framework (which takes into account current pricing, and considers the return that we can expect if the market moves from current levels to our equilibrium assumptions).

Inflation beater

Data over 110 years to end-2009 shows that SA equities have provided a handsome return of almost 15% per year. This is approximately 8% per year above the average rate of inflation over the same period. Even over the five-year period to end-December 2009, equity returns were just under 20% per year - although this period included the terrible 2008 market correction.

If the 110 years is any guide, long-term equity investors can take heart from this history. It supports the view that over long periods SA equities should generate returns of approximately 8% per year above inflation.

But this doesn’t consider current market levels. For example, if equities are currently priced below the long-run average or fair-value level - and we assume that, over a reasonable period, the market will return to equilibrium - the returns from equities may be higher than our long-term assumption. The opposite is true if equity markets are expensive.

Past equity returns

Detailed data, available since 1960, offers these insights:

  • Dividends have made a stable contribution to equity returns over time. They consistently contributed between 2,5% and 4,5% per year to total equity returns over this period;
  •  Earnings growth measures the increase in the total profitability of the companies that make up the equity market. This is the biggest contributor to total returns, but is also the most volatile. Over the past five years, the rebound in corporate profits after the 2002-03 recession created particularly strong earnings growth;
  • The ratings change (the change in the amount that investors are prepared to pay for a given level of future earnings growth and dividends) is commonly measured as the change in the market’s price/earnings (p/e) ratio. Over longer periods, these changes contributed little to total returns.

This is no surprise because, over time, the market should trend towards its long-term average p/e rating. However, over shorter periods and even over the past 15 years, ratings changes have in fact reduced returns. This is probably the result of investors becoming much more fearful of equities as an investment after the 2008 correction, and selling down equities to well below a “normal” ratings level. Such events are good buying opportunities.

Clearly, when you buy assets cheaply you can expect to earn better future returns.

Let’s explore this a little further. The graph below plots, for a number of month-end periods, the subsequent five-year return delivered by the JSE All Share Index, relative to the p/e ratio of the market at the start of each five-year period.

A few observations:

  • At the current JSE level (a p/e ratio around 12,9 at time of writing), the market appears to be neither cheap nor particularly expensive;
  • The more expensive the market at the start of the period, reflected by a higher starting p/e ratio, the lower the subsequent five-year return. The cheaper the market at the start of the period, the higher the subsequent return.

At time of writing, the JSE was trading on a forward p/e of 12,9. If history is anything to go by, the return one could expect from buying equities at these levels will probably vary from about 10% to 20% per year over the next five years. These returns are likely to exceed inflation by a handsome margin.

Power of compounding

If in 1990 you invested R1 in the equity market, and you reinvested the declared dividends each year, the compounded effect of these reinvested dividends would have contributed nearly 50% of your total return to the end of 2009. Your R1 investment would have grown to about R18 – and close to half of that would have come purely from dividends reinvested. The reinvestment effect is powerful.

Outlook for future

Equity investors remain nervous about the possibility of slow global economic growth, and even the risk of a double-dip recession. It’s easy to understand why investors would be concerned.

But if one stands back from the noise and focuses on current market valuations, to consider the actual past history of asset-class returns, equity investors will be well rewarded for holding equities in their portfolios. Although short-term returns continue to be highly volatile, on a longer-term horizon there should be increasing confidence in decent inflation-beating returns from equities.