Getting better...

...by a process of continual improvement or Kaizen the Japanese term for this which became prominent in the 1980's when it seemed that Japanese businesses were dominating the world and their stock market was on a crazy rating which it has never recovered from to this day. Any way that doesn't stop the principle being a good one and with that in mind I have been applying it to the Compound Income Scores this week.

If you are a regular reader you may recall that I recently added an extra column to these to calculate an estimated sustainable growth rate to help with longer term projections. So this week I have hopefully taken this to its logical conclusion and introduced some suggested expected return columns. These are based on the forecast, five year historic dividend growth and the suggested sustainable rate which are already in the sheet.

By way of explanation, these are simply the current yield plus the calculated growth rate. I have headed these columns up:
MIN (the lowest growth rate for a conservative estimate), MEDIAN (the middle growth rate) AVERAGE (the average of all three) and MAX which should be self explanatory. Obviously as I say this is a simple suggested expected return and actual outcomes are likely to differ depending on how the market overall moves and if the stock concerned get re-rated or de-rated over and above the movement in the dividend or if the company ends up disappointing or surprising on the upside in the short term.

How should you use this? Well I think you would do well to take these figures into account when picking your stocks and compare it to the valuation, which is what the EVER ratio on the sheet does using the one year growth forecast.
if a stock is highly rated there is a risk that the growth may not come through in the rating or it could be more vulnerable to a de-rating if it disappoints.

Overall I would tend to look for an expected return on this measure of 7 to 9% or say 8% on average and you might want to look for say 10%+ which is a nice round figure for a margin of safety, especially if you are looking at a smaller or AIM listed stock. However, this type of analysis is probably of most use for steady growing / compounding type stocks. As those with a low minimum figure will probably reflect limited growth or previous cuts so you may not be able to rely on them delivering consistently in the future. I would also tend to ignore the maximum figure because again this may just reflect dividends being reintroduced from a low base, an artificially high ROCE  or a short term ramp up in the dividend which may not be sustained in the long run.

Now why do I say you should look for 8% or so suggested return?

Well, in the long run the average real (after inflation) returns from UK equities have been 5.3% per annum since 1900 and 6.2% between 1965 & 2014 (Source: Credit Suisse Global Investment Returns Year Book 2015 - see page 57 in file attached at end of this note.) So lets say 5.5% for the sake of argument. So since you are looking at equities here it would seem logical to want to at least get an average and preferably, an above average real return on your investment for taking on equity risk. There is a good discussion of real discount rates and equity risk premiums in the Credit Suisse document starting on page 29 if that is of interest to you, but I'll discuss this in a moment in any event.

You will need to factor inflation into the calculation to compare with the expected return figures. Looking at data from the Office for National Statistics in the UK I note that CPI between 1997 and 2014 has averaged 2.1%, while RPI over the same period has averaged 2.9%. So while the Bank of England likes to target 2% on CPI and you could use that I think I'd prefer to use the average of the two so lets say 2.5% for the sake of argument.

So we now have a suggested long term nominal market return of the expected equity risk premium of 5.5% + inflation assumption of 2.5% = 8%, but of course you could use a higher or lower figure depending on what assumptions you want to make and what margin of safety you want to factor in to allow for disappointments.

I would then tend to combine this expected return figure with looking at the valuations. Ideally you might be able to find a stock with a decent yield - say 3%+ combined with a reasonable PE of say less than 15x and a decent earnings yield of 7 to 8%+ and a better than average Compound Income Score. However with regard to these figures and the Compound Income Scores, please remember to use them as a guide to potentially attractive shares which may be worthy of further research, as you need to assess the underlying business and its likely prospects which underpin the numbers.

Hope you find this useful - the Scores have been updated today to include these return columns. If you are not already signed up and would like to gain access to them then please read more about them and how to sign up here.

global-investment-returns-yearbook-2015-v3.pdf
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