Wealth Intelligence

Investment clarity

Two matters worth noting are...

1. Don’t be spooked by a negative share-market quarter.

There was much consternation because of the negative return for the Australian share-market in the September quarter.

The return was barely negative: -0.3%. But after the strong share-market run, some investors seemed to forget that the market can go down.

It is important to put quarterly market returns in perspective. Negative quarterly returns are common in equity investing.

If you invested in the market at any time since 1980 you would have had a 1-in-3 chance of your first quarter providing a negative return. Furthermore, you would have had a 1-in-5 chance of a negative first 12 months. And if you were really unlucky you would have had a 1-in-10 chance of a negative 3 year return (with the data heavily influenced by the 2007-2009 market period).

What should also be apparent from this, however, is that the longer your time frame the less likely you are to have negative returns from the market.

In fact, you would never have made a return worse than 5.9% p.a. over any ten year period (this includes the 1987 ‘crash’ and the GFC) had you invested at any time in the past 34 years.

Therefore, investors today, in both bull markets (i.e. rapidly rising markets, e.g. 2007) and bear markets (i.e. falling markets, e.g. 2009), should not wrestle too much with anxiety over quarterly returns – provided they are invested sensibly and for the right time period.

2. There are three sources of investment return. Don’t miss out on the third.

There are three sources of investment return: (i) dividends; (ii) share price growth from profit growth; and (iii) share price growth from ‘valuation’ i.e. changes in the P/E1 of the market or of stocks.

Since 1896 the Australian share-market has returned about 12% p.a. Approximately 34% of this return has been from company dividends and about 66% from profit growth. There has been virtually no investment return, positive or negative, from changes in valuation.

Since the market trough after the GFC (March 2009) the market has returned about 14% p.a. Of this, the return from dividends was about the long- term average of 34% of the total investment return.

But the return from profit growth was just 24% of the total. The balance of 42% came from valuation, i.e. change in P/E.

First Hand Spring Summer14 graph 2 1280pxW

Most of the investment return from the post-GFC market trough has been the market P/E increasing from about 10 to reach close to its long-term average of 14.7.


But the return from valuation can be negative, as well as positive. And if in the long-term the return from valuation is zero, surely it is better to own a portfolio with a low P/E, rather than a high P/E?

So the opportunity now is for investors to rebalance their portfolios to have a lower average P/E. This will assist in ensuring that long-term return from valuation (the third source of return)
is positive. The alternative, allowing the portfolio P/E to keep rising, would increase the risk of a negative return from valuation.

Caution

Buying a portfolio of stocks with a low P/E sounds good in theory. But investors must also ensure that they avoid stocks that have a low P/E because they have low dividends and/ or low expected profit growth.

Summary

It is unwise to ignore the opportunity of a return from valuation. But do so sensibly.

You should make sure that, on average, your portfolio has:

a. Good dividend yield

b. Good expected earnings (i.e. profit) growth

c. Low P/E

As First Samuel has for our clients. It makes sense.

IMPORTANT NOTICE:  Any advice contained in this document is of a general nature only and has been prepared without taking into account your personal objectives, financial situation or needs.
Because of that, before acting on any advice in this document, you should consider whether the advice is appropriate for you having regard to your personal objectives, financial situation and needs.