A few weeks back I ran a seminar in the City for private investors on the subject of whether the markets reckons the FTSE 100 represents good value.
Clearly, I have no special insight into this eminently sensible question, especially as I long ago gave up trying to work out how the markets move in the short term. Sadly, this mixed bunch of over 60 investors expected a rather more definitive answer rather than my “maybe...depends on what you’re looking at”.
After the talk a few dutifully shuffled up to the front and accosted me, demanding to know whether I would stick my money in the market now. My rearguard action consisted of yet more conditionality. Lines like ,“even if its fair value that is no reason to stop with a monthly savings plan,” trotted out alongside the balancing observation that, “If I had a large bunch of cash I would be wary of committing it all in the autumn”.
But one particularly insistent young investor would not take no for answer and proceeded to ask me the killer question, “but how exactly do you make money on equities?”
I was tempted to reply: “You have not over the last ten years.”
But instead I dutifully trotted out the line borrowed from the LBS study on long term returns and suggested dividends are what really matter - dividends paid out and dividends reinvested.
To which he replied: “Oh yes I saw that study mentioned somewhere else but wasn’t that just about the US and the UK. What about the rest of the world?”
To which I had no answer at the time, although now I would direct him to a handy little paper from the MSCI Barra research team called What drives long term equity returns (January 2010).
I thoroughly recommend grabbing this short paper as it benefits from a detailed analysis of returns on the key MSCI developed World index over the last few decades.
Like many studies this breaks down long term returns data (1975 to 2009) on a number of discrete components including inflation, price to book growth, real book value growth, and dividend income.
Over the full period for the MSCI World index we would have received 11.1% from investing in the MSCI World index, with inflation accounting for 4.2% of that growth, price to book growth 1.5%, real book value growth 2.1% and dividend income 2.9%. Volatility of the price to book growth component was a stunning 14%, while volatility on the dividend income a lowly 0.4%, although it is worth noting at global level dividend income has been slowly declining as major factor.
Looking in particular at the MSCI UK index the authors suggest an equivalent return of 15.4% annualised gross return (0.8% for the last decade) with inflation accounting for 5.4%, price to book growth 4.2% and dividend income a chunky 4.1%. In the UK the authors report: “This out performance is mainly due to their higher inflation rates and dividend yield”.
So, what would I tell my young investor armed with this analysis? The first is that these long run data series tell us bugger all about where the markets will trend in the next 1 to 24 months - markets will wander around a long term mean for much longer than any rationalist can imagine.
I would then repeat one of MSCI Barra’s conclusions - “The analysis showed that after inflation, dividend income was the most important part of equity returns for the majority of markets”.
So do not forget to reinvest those dividends and stay loyal to progressive dividend payers.
But I would finish on the inflation point - the UK has suffered structurally high levels of inflation for far too long. Increasingly a bet on equities is a bet on inflation. If you believe inflation will remain systemically high, then there is no reason to believe equity returns will not be returning to double figures on an annualised basis.
But, if like some, you believe we are being dragged inexorably towards the rocks of deflation, then we should expect to knock at least 2% to 4% off the annualised return figure as inflation falls away - and this contraction will be made worse by the threat of book value contraction as deflation destroys asset valuations. In which case suddenly all those fixed income government bonds yielding next to nothing might begin to represent decent value....
David Stevenson is a Financial Times columnist and consultant.
Email him at davidcstevenson@gmail.com
