Wednesday, 02 November 2011 - 20:00

 

Charts

Components of Return

If one had taken a poll across a range of investors and even professional fund managers at the end of September after the local market had fallen 3,6% and global equities were down 8,6% and 16,5% over the 3 months, it is highly unlikely that even one would have predicted a return of 9,4% for local shares in one month.

It is this high monthly and even quarterly volatility that in fact frightens off many investors. But if one understands the drivers of performance, then investors with a longer term investment horizon can take advantage of shorter term mispricing.

The question then is this – just what drives the return on an investment in a financial asset – i.e. an ownership stake in an underlying business?

There are 2 main components of return, which may be further subdivided into 3 components:
• In the first instance an ownership stake in a company gives an investor access to the dividends declared;
• Secondly an investor stands to make a capital gain – i.e. the difference between the price paid for the share and the current selling price.

While most investors understand the concept of dividends – i.e. the excess profitability paid out by a company, what is less understood is what drives the capital gains component. Well, we can break down the capital gains component into 2 elements. The first is the growth in earnings per share and the second is the change in the price paid for these earnings.

As an example: Company A, generates earnings per share of R1,50 and the price is trading at R16,50 – i.e. a multiple of 11 times the most recent earnings. Over the next 3 years, should earnings per share move up to R2,20 a share, and the market is prepared to pay the same multiple for these earnings, i.e. 11 times, then one can expect the price to trade at R24,20.

One alternative is that the earnings grow to R2,20, but the investors are now prepared to pay 13 times and not 11 times for these earnings, then the price will ratchet up even further to R28,60. It is clear from this that an ideal scenario for an investor is where a company pays out strong dividends, continues to grow its earnings and over time investors are prepared to pay a higher multiple for these earnings.

While there is a higher degree of stability in company earnings and the payment of dividends over time, what does tend to fluctuate, sometimes on an almost irrational basis, is the multiple paid for these earnings (the price earnings multiple or PE ratio). At times investors become very pessimistic about the future and are only prepared to pay less than 8 times for R1 of earnings and at other times they act with exceptional enthusiasm and are prepared to pay 20 – 25 times per R1 of earnings.

Sanlam Value fund managers segmented the JSE historical returns from 1960 into bull, bear, and range bound markets and aggregated these 3 components in each phase as follows:

From this analysis it is very clear that in various market phases earnings and dividends are positive, but it’s the price paid for these earnings that is volatile and indeed has by far the biggest impact on the total return over defined bull and bear phases.

But what is very important to remember is that while PE multiples tend to be volatile over shorter and medium periods of time, they will never keep on moving in one direction (up or down) forever. Over the extended period there is a degree of normalcy with this rating change making a far lower contribution that would typically be expected. A study by JP Morgan notes that over 40 years to the end of 2010, rating change added only 2,6% per annum out of a total of 20% per annum. Over the 10 year to end of December, PE rating change had subtracted an annual 1,4% per annum.

What this tells us is that times of high earnings multiples will be followed by times of low multiples and vice versa. This is one of the major reasons why formalising an tactical asset allocation strategy is so important – i.e. a process that will down weight exposure to equities when investors are paying too high a price and conversely increase weighting when investors are too bearish.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Wed, 02 Nov 2011

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