As you may know from some other posts in the past, I am generally a buy and hold kind of investor who does not generally try to time the market. This is because timing the market is incredibly hard to do and I also prefer to allow time in the market and the power of dividends and compounding to work their magic. See a good piece from a useful website called 7 Circles for more on this.
However, with equity markets around the world flirting with all time highs as I write and with the US Federal reserve about to raise interest rates for a third time, I cannot help but start to feel a little nervous. This is compounded by the fact that US equity valuations in particular are looking somewhat stretched and towards the top of their range. Now while this in itself is not that helpful as a timing indicator, it does suggest however that returns from US equities may not be that great from this point. There was a good post discussing this in more detail which can be accessed by clicking the image below.
Thus given where Sterling has fallen to against the US Dollar I certainly would not be chasing US equities up here especially as the old saying goes - "don't fight the Fed." Nevertheless UK equities still look less stretched, but would not be immune to a shake out on Wall Street if the current rising rate cycle should lead to problems down the line.
Interestingly Neil Woodford put out a note pointing out the attraction of dividend yields in the UK Market and the benefits of taking a longer term view which reduces the risks of suffering losses, although he does have a new fund to sell - so he would say that wouldn't he? Nevertheless the article in the link above and an earlier piece a colleague of his did called - Are UK Equities Overvalued? - are both worth a look. In particular the second one suggests that the UK could offer 8% real returns based on its current valuation, but does caution that this could be undershot as it has been in recent decades. Interestingly Research Affiliates 10 Year Expected Returns analysis shown above also seems to confirm this and suggests you should probably invest anywhere except the US.
If you are taken by his arguments and evidence of the benefits of investing for the long term, then his new fund, the CF Woodford Income Focus Fund, will be available for investment from 20th March 2017, with the launch period closing at midday on 12th April 2017. Alternatively if you want to go your own way and do it yourself to save the fees, then don't forget the Compound Income Scores are available to help you identify good value, quality growing dividend stocks for further research.
Summary & Conclusion
Another old saying is that the market climbs a wall of worry and it may be that I'm worrying prematurely about rising US interest rates plus the fact that while valuations can be a good indicator of future returns they are not very good as a timing indicator.
Talking of which the timing indicators that I follow like the trailing 10 month moving averages, US Unemployment and PMI data plus general economic news are all still generally supportive. Thus despite the high valuations in the US, given the current economic background and the reasonable valuations in the UK, I'm inclined to extend my time in the market further and carry on compounding my dividends.
Of course if the US does catch a cold then the rest of the world will probably get influenza and likely lead to some downside when and if that happens. However this would then likely throw up more opportunities and an even better entry point in terms of timing and valuations.
... I thought was an appropriate title for this piece as we saw the launch this week of a new film version of Dad's Army in which no doubt the latest incarnation of Corporal Jones will utter his famous catch phrase. So what's that got to do with investing I can hear you thinking. Well the don't panic phrase is a good one to try and remember when we are experiencing volatile markets such as those seen this January and since equity markets, with the benefit of hindsight, topped out last spring / summer.
Now some readers may be younger than me and indeed you may have only got interested in the stock market in recent years when it seemed like it only ever went up. While some will be older than me and have seen it all before no doubt. But it is worth remembering that equity markets only go up about 60% of the time and in a bear market which is defined as a 20% drop from a top, they can and do go down by 30% to 50% or more as we saw as recently as 2008/9. In extreme cases when certain markets are unwinding from bubble conditions they can and do usually fall by around 80% or more from the peak - think .com stocks back in the early 2000's for a recent example of that.
Having said all that investing in equities for the long term (10 to 20 years) has in the past delivered decent real (after inflation) returns in the region of 5 to 6% per annum which is always worth remembering, but whether you achieve these returns is largely dictated by the price or rating you pay at the outset. Swings in ratings both up and down help to drive secular bull and bear periods in markets which seem to have lasted on average around 17 to 18 years. It seems to me that having had a 17 year or so re-rating which peaked out in 2000 with the .com bubble, we have remained since then in a secular bear market as the FTSE has failed to make a decisive break into new high ground. This has not however precluded big swings a profitable period within that along the way, which is also in common with history. Any way if you want to read more about the theory of these long cycles I would recommend a book Stock Cycles by By Michael J. Alexander - as featured in my Resources list of recommended books and other useful things. Included on there is a link to Crestmont Research - which is really useful resource for swatting up on market ratings history and secular bull and bear markets.
Aside from that I read a good piece on AAII.com recently which included some useful thoughts on a more rational approach to portfolio valuation. This basically talks about thinking like an owner as Warren Buffet talks about and having in mind a fair PE rating for the stocks you own. It suggests you then compare the rating that Mr Market is putting on your stocks and decide whether that is under or over valued and act accordingly rather than being influenced by noisy share price movements along the way. Seem quite sensible to me and well worth a read if you have been panicking about recent price moves on stocks in your portfolio.
Now for me the other longer term thing I focus on, as you know, is the income you can get from the dividends and compounding those. In a similar way to the article above, by focussing on these and what you think might be a fair or minimum yield you would expect on your stocks, you can also take a longer term perspective. Indeed it is also noticeable that in the past, although no guarantees for the future, that dividends have tended to hold up a lot better than prices during bear markets. This was evidence most recently in the 2008/9 bear market and subsequently when the UK stock market fell by around 50% but according to data from Capita (see page 6 of report) total dividend payments only fell by 14.3% between 2008 and 2010. They have since 2010 gone onto rise by 49% which represents an exceptional rate of growth of 8.3% per annum over the five years since then. I say exceptional as in the long run real dividends have tended to grow by more like 1 to 2% in real terms and indeed if you look at all the data in the Capita report on page 6 and include their forecast of a small fall in dividends for this year then the growth rate over the whole 9 years is likely to be closer to 3.5% per annum which in real terms will be closer to the long run average.
On the subject of dividends and their volatility versus the market prices there was an interesting look at the history of this in the US at A wealth of common sense - called The Incredible growing dividend. Now while this was US based data it did help to highlight why I like to focus on growing dividends and compounding them over time. Further to that there was an update last year to research from the value house Brandes Institute called: Income as the Source of Long Term Returns. This looked at the importance of dividends in the long term, the dividend yield gap versus bonds and also the stability of dividends in the longer term. Indeed they found that the volatility of the dividend streams themselves was a very small fraction (under one-twentieth) of the volatility of stock price movements.
From this report I particularly liked the lessons from the following extracts:
The message in Exhibit 7 is clear: higher dividend-paying stocks delivered higher total returns. While this was partly due to the dividend return, it is also notable that on a price-only basis, the top three quintiles of dividend-paying stocks had higher price and total returns than quintiles 4 and 5, as well as the non-dividend-paying stocks.
We have stressed the long-term nature of this research. However, many investors still have concerns over short-term price volatility. Did a focus on higher yielding stocks cause exposure to extreme stock price fluctuations? Again, the answer from our research is “No.” In Exhibit 8, we look at volatility of both stock prices and dividends within the quintile universe. Volatility of stock price returns was lowest for the highest dividend yield stocks, and increased steadily as dividend yields declined. So investors in the top quintiles received both higher returns (Exhibit 7) and lower volatility (Exhibit 8). My emphasis on the last bit there as that is as close to investing Nirvana as you can get I would say. I would also highlight that they also observed:
We have long held that paying excessive attention to short-term price movements is a behavioural error that can lead investors to make bad investment decisions. The data in this research suggests that investors might do much better to focus on their portfolio’s income stream as it develops over time. Exhibit 8 shows that the volatility of that dividend income stream was a very small fraction (under one-twentieth) of the volatility of stock price movements. To the extent that volatility causes investors to worry, switching attention from price volatility to dividend volatility might ease that worry substantially.
Summary & Conclusion
So definitely worth focussing on the income and thinking long term to avoid worrying about short term market volatility and making behavioural errors as a result I would say. Having said that though in the short term it is worth bearing in mind the Capita forecasts and the suggestions of others that dividends are more vulnerable now as levels of cover in the UK have been run down to low levels, so I suspect the outlook for dividend growth from the market overall may not be as good going forward in the short term, but do try and think long term and don't panic.
This is especially obvious in the UK given the concentration in income from the top 5 stocks which represent 33% of the income while the top 15 represent over 50%. As the top 5 all have question marks over the sustainability of their dividends, this is worth bearing in mind if you are investing in tracker funds.
That's why I prefer to invest and seek out companies able to grow their dividends in a diversified fashion so my income is not dependant to a large extent on a handful of companies and should therefore give me a growing income stream to live off of and compound over the long term as hopefully I might have another 20 to 30 years on this planet if I'm lucky. Or as the Brandes Institute put it:
We believe this research illustrates that the industry acceptance of five years as a long-term investment horizon underestimates the potential of reinvesting and compounding income. By reinvesting the income contribution of investment returns, investors can leverage the power of compound interest. Investors should not let recent market experience distort their perspective, and particularly should avoid preconceptions that income is less important than capital gains in its contribution to total equity returns. Income has served as a significant component of returns, and the combination of reinvested income and capital appreciation historically has presented the best option for long-term investors to realize optimal returns.
Cheers have a great weekend, whatever you are up to. Finally to bring the post to a close and to bring it back full circle to the title - as it is the weekend and it has been a while since I inflicted any music on you - here's a song from a new band The Brothers Osbourne called - Stay a little longer which seems appropriate in the context of this post.
Here we go as threatened / promised is part 3 of this film themed set of posts looking at what we can learn about the future for investing by looking at the past. Since the third Back to the Future film was set in the Wild West this post appropriately will take a look at markets which some categorize as the Wild West given their volatility and propensity for crises.
Since sequels often rehash what has gone before lets start by recapping the first two parts. in the first part we saw that real returns from UK equities have been in the region of 5 to 6% in the last 50 to 115 years. We also explored the fact that we have been in a secular bear market since 1999 as the market was on an extended valuation at that time. This highlighted the importance of the valuation levels in determining future returns. We then went on to look at current valuations in the UK market based on dividend yield data from Capita Asset Services. This suggested, that based on current levels of dividend distributions from UK companies, that in the long term future from here, we might be able to look forward to real returns from UK equities roughly in line with the 5 - 6% long term averages, which is nice.
In the second part I left you in the hands of Professor Hans Rosling to talk about demographics and its effects on countries and their prosperity etc. If you have not had time to watch it (spoiler alert) the summary is that the worlds population will continue to grow before levelling out. Most of the remaining growth is going to come in Africa and the Far East and there are good reasons to believe that many in these regions will continue their journey out of poverty towards greater prosperity as their populations grow and their economies become more developed.
Essentially the demographic trends seem to be pointing us towards emerging markets, although this is not a new idea although it has been found that investing in the highest growing economies has not always been a recipe for success. See the Global Year Book 2014 which had articles on Emerging markets v developed markets starting on page 5, and high v low growth economies and counter intuitive future investment returns on page 17. So in this third part I thought I would look to the future and see if it might be worth looking to play those demographic trends in emerging markets and maybe other developed markets by examining current valuations of global equities.
With the growth caveat in mind lets think a bit about the history. Emerging markets as an asset class really started to develop and become more mainstream in the late 1980's and early 1990's as far as I remember. However, I guess some pioneering investors, such as the late great Sir John Templeton, were early emerging market investors with their investments in the likes of Japan and Hong Kong before these became mainstream. Indeed in the Global Year Book 2014 which I mentioned above, the professors travelled further back in time to 1900 by defining emerging or developing nations based on GDP per capita being less than $25,000 rather than index provider definitions. This suggested that developing markets, on this definition, had produced annual returns of 7,4% and had underperformed developed markets which had produced 8.3% per annum since 1900.
These returns were however, hit somewhat (classic English under statement there) by the the 1917 Russian revolution when investors lost everything and a post war collapse in Japan when investors effectively lost 98% in dollar terms! In addition another contributor was China, where markets were closed in 1949 following the communist victory, and where investors in Chinese equities effectively also lost everything. However the authors do point out that from 1950, emerging markets staged a long fight back, albeit with periodic setbacks. From 1950 to 2013, they achieved an annualized return
of 12.5% versus 10.8% from developed markets.
In their current guise what today are known as emerging market according to index providers are often referred to as the BRIC's (Brazil, Russia, China, India) a phrase coined by Goldman Sachs, plus many other Far Eastern and frontier African markets which have been though several rounds of enthusiasm and pessimism and associated booms and busts. Their strongest period of outperformance came in the decade after the developed markets peaked in 1999/2000 after the dot com bubble and as enthusiasm for growth in emerging markets really took hold. They have however, in the last five years or so, underperformed badly with the MSCI Emerging Markets ETF being down by around 15% versus a rise of 85% for US equities & +15% or so from EAFE equities (developed ex US) over the same period, see chart below. After that I provide some graphics looking at valuations on Global markets and I will discuss the implications of these after these which are:
excellent Asset Allocation resources provided by Research Affiliates. The graphics look at :(1) Shiller PE's on global equities, (2) Expected 10 year risk and returns across different asset classes and (3) Expected 10 year risk & returns for individual equity markets.
At certain times in the past investors have been prepared to pay a premium for emerging markets and then been disappointed by returns as the natural volatility of these economies and markets kicked in. In fact the important point to remember when investing in emerging markets is that they tend to be much more volatile than developed markets so you need to be prepared to accept that if you are going to invest in them. At other times in the past investors have become very pessimistic about emerging markets after various crises in the Far East and Russia and may be even after the current China crisis if that's what it is. Returns have then tended to be better because, as we learned in part one, future returns obviously tend to driven by the price or valuation you pay at the outset.
It's noticeable that Emerging markets overall and Brazil, China and India are all close to their lows in terms of their Shiller 10 year PE. Meanwhile US equities & Japanese equities look relatively expensive on 25x and 24x while UK and EAFE look more reasonable on 11x & 14x respectively. While CAPE is not necessarily a good short term timing indicator, it does suggest a bias away from US equities and towards other developed and Emerging markets could be good for future returns on your portfolio as per the Real 10 year expected return chart above.
In passing before I get on to the summary and conclusion it is encouraging / reassuring to see that they also suggest 6% real returns from UK equities over the 10 years confirming what we saw from looking at the Capita dividend based calculation in part 1.
Summary & Conclusion
So far in this series we have seen from studying the past that the price you pay is important for you potential future returns. While a talk on demographics suggests that emerging markets might be a fruitful hunting ground for future growth and increased prosperity, although we also touch on in this part the evidence that rapid GDP growth does not always necessarily lead to above average investment returns, so that is worth bearing in mind too.
However, despite that caveat, the demographics and a look at current valuations suggests that there may some potential from decent future returns from some developed markets and emerging markets going forward in time from here. It is however important to remember that emerging markets are likely to be more volatile than developed markets so you have to be comfortable with that if you are going to consider investing in them.
With that in mind I think I'll go one better than the makers of the original Film series and come back in the future with a part 4 and have a look at ways you can play these areas via London listed vehicles and investment trusts. Still I guess you can never rule out another Back to the Future film because the fashion in Hollywood these days seem to be to re-boot or resurrect old tired franchises - evidence for the prosecution - Jurassic World, Mad Max Fury Road, Terminator Genisis, Star Wars whatever - you get the picture, The End.
With another quiet day in the markets and after my trip down Memory Lane, today I thought I'd start a Back to the Future series. This of course was also a Film series which started back in and was originally set in 1985 and involved the star Michael J Fox travelling back in time to 1955. In addition in the sequel he travelled forward in time to 21st October 2015 which just happens to be tomorrows date. There is an amusing Wiki page dedicated to the series and this link explores the technology that the film makers guessed we might have by now. So we didn't get the Hover board or the auto drying jacket but we did get the video phone and I'm pretty sure that supermarket frozen Pizzas are a good attempt at dehydrated Pizzas!
So what's this got to do with investment I can tell you are thinking? Well I thought I would go back in time and reference some old data and then return to the current day to see what it might be able to tell us about the future. So with that in mind I would suggest you might want to revisit the resources page on the site and look up the Global Year Book 2015 which appears in the useful websites section or click the highlighted link to download a copy.
Following on from the UK Vice post this also has a section starting on page 17 titled Responsible Investing: Does it pay to be bad? This comes to a similar conclusion to me, but it might be interesting for you to read in more detail as activist investing can work too. Amongst other things the document then also goes onto look at returns from global assets classes over 115 years back to 1900. This is then repeated for the various countries around the world reaching the UK on page 57.
This shows that in the long run, the 115 years covered here, although that is clearly too long for most folk except perhaps for babies born to day or in the future with the advances in healthcare etc. Any way this shows that the long term real (after inflation) return on UK equities has been 5.3%. Meanwhile over a more realistic investor lifetime taking the 50 year period from 1965 to 2015 the real returns were 6.2% although I think this figure may be distorted slightly upwards by the lengthy bull markets in that period and a consequent boost from a re-rating of equities over the period. So I think the more normal range of real returns to expect would be more like 4 to 5% in normal circumstances unless you are starting from a particularly depressed valuation level.
The importance of the starting valuation and its effects on future returns is highlighted by the returns which have been earned since the year 2000 when valuations were at extremely high levels. This has led to real returns from UK equities being only 1% over the 14 years to the end of 2014 in what could be described as an on going secular bear market as the FTSE has still failed to convincingly break above the levels it traded at in 2000.
So with all the recent concerns about global growth and consequent market volatility, what might the future hold for returns from here? Well for this I'm going to reference a document which was mentioned in the press yesterday and featured in my twitter stream - the Capita Asset Services Dividend Monitor Q3 2015 which you can download here. This shows 5.9% growth in underlying dividends from UK companies this year and they expect these to reach £84.8 billion by the end of the year which would be up by 6.8%. This is a decent level of growth and is probably above the long term average of real growth in dividends with inflation running at perhaps 1% or less this year.
They do however flag that they expect to see this growth slow to just 3% nominal in 2016 as the effects of recent cuts from the likes Glencore and Standard Chartered feed through. This would put real growth into the 1 to 2% range which I think is more like the sort of rate that one would expect in the long run. Now in case you think I'm making that up take a look at the following graph from the Capita report:
Looking at the underlying dividends we can see that since the end of 2007 these have grown from around £61bn to the expected £85bn or so to the end of this year. Thus over the 8 years this represents growth of 39.3% which represents an annual growth rate of 4.23%, despite the fall in dividends in 2009/10 and as such represents a trend including both good and bad periods. UK CPI over the same period including this years expected 0.3% 2015 rate (Source: H M Treasury consensus forecasts October 2015) gives an average CPI of 2.6% per annum or 3.4% for RPI. Thus the real dividend growth using CPI has been 1.63% per annum since 2007 or 0.83% using RPI. Thus on the CPI measure of inflation this puts real growth in recent years in my suggested 1 to 2% range or slightly below using RPI. Taking an average of the two inflation rates would give a 3% rate of inflation and suggest that real dividends had grown by 1.23% per annum.
Summary & Conclusion on Future Return Expectations
So lets look to the future to see what we can see. In the Capita report they suggest that the forecast dividends for next year represent 3% growth in nominal terms and the average forecast for CPI for 2106 is 1.7% to give real growth of 1.3%.
They also suggest that the dividend next year will give a yield of 4.1% which as they say means equities have the best
yields of major asset classes.
Thinking long term this suggest to me that from these valuation levels we can look forward to real (after inflation) returns from UK Equities in line with or around the long term averages of 5 to 6%. This comes from the yield suggested by Capita of 4.1% for next year. So lets say for the sake of simplicity and to be slightly conservative 4% yield to which you can add assumed real dividend growth of 1 to 2% per annum which should give you total real returns in the region of 5% to 6%.
So there you go I think valuations seem fine on that basis at the moment and investing on these terms should be fine for the long term. However, obviously there are some concerns about dividends from some of the larger sectors like miners and oils and we have seen cuts in recent years from Banks and food retailers, but nevertheless dividends have continued to grow overall over the piece. Thus I wouldn't get unduly worried about more cuts although I accept that cover levels have come down a bit in recent years overall, which could crimp growth or make levels of dividend vulnerable in another downturn, but for now the economy seems to be doing fine and is forecast to grow at a similar rate next year.
As ever I guess time will tell in the short term and the long tern is but a series of short terms, but in the meantime relax, let your dividend roll in and enjoy this video about the things we were supposed to have by now according to the makers of Back to the future!
I saw an interesting article today (which I shared on Twitter earlier) in the Daily Telegraph in which Ambrose Evans-Pritchard wrote up a note from the Morgan Stanley strategist Graham Secker. I remember him from my time in the City and I rated him highly as he made some good call and does interesting research. The write up is about his technical indicator which measures market valuation and sentiment etc. and includes a chart of the indicator which is shown in the chart. You can click the image to read the article which I highly recommend, although it is worth noting this isn't a signal to rush out and buy today. But it does suggest some well chosen contrarian purchases down here while everyone else is losing their head might bring you some decent returns in the medium term.
We also had a trading update from Diploma (DPLM) today which is in the Mechanical Compound Income Scores portfolio and currently has a score of 82 which is lower than when it entered the portfolio. It is also therefore getting close to the sell threshold so this may well be one that is heading for the exit at the next quarterly review at the end of September.
This seems more likely now as the update, while positive in parts, did allude to some headwinds on underlying turnover and margin pressure. However some of this related to a relocation of operations in the seals business and lower margins on some new acquisitions. These (acquisitions) have been and continue to be part of their business model and quite often they then ramp up the margins so this may not be such a concern in the medium term.
However I suspect it may lead to some downgrades in the short term and therefore could hit the score some more too. Before any changes and with the shares off by 7% this morning this leaves them on a still fullish looking 18.5x this years currently forecast earnings with a 2.6% yield. So I wouldn't suggest buying this one just yet and indeed with the slowdown in growth to single digits the rating still looks a bit rich so you could perhaps even call it a sell?