Understanding the source of past returns is the key to estimating the likely future

February 10, 2021

3:07 pm

“The stock market is full of dollars selling for much more than a dollar. A dollar that consistently sells at 1.1x face value may even be respected for the consistency of this quality, earning it the “right” to have that premium.

“These are not the investments your portfolio manager chooses for the Fund. A wildly fluctuating dollar selling for 40 or 50 or 60 cents will always remain more attractive – and far less risky. As for my loneliness at the lunch table, it has always been a maxim of mine that while capital raising may be a popularity contest, intelligent investment is quite the opposite. One must therefore take some pride in such a universal lack of appeal.”
Dr Michael Burry[1]

Although it now seems to be an old-fashioned notion, buying a share in a company used to be considered as an act of buying ownership of a future stream of income from a business. A sound investment strategy was thought to be one that tried to pay less than the net present value of that income stream in order to provide the investor with a reasonable return and a margin of safety. Today, investing for many seems to be focused on paying significantly more than the intrinsic value of a business in the hope that they can sell it on to ‘a greater fool’ at an even higher price. As the Robinhood traders in Gamestop have just discovered, however, that can go badly wrong when the music stops, and you are left holding a share priced at significantly more than it is worth with no-one willing to buy it from you.

It should be self-evident that there is an inverse correlation between the price you pay for that future stream of income and the return you get on it. To keep matters simple, let’s use just one income payment of £1 in five years’ time. If you pay 33p for it today, your return is 25% p.a. If you pay 75p your return is 6% p.a. and if you pay £1.1 your return is -2% p.a.

One thing that should jump out from this is that lower interest rates do not make that stream of income more valuable. There is no change in the £1 that you receive in five years’ time. When you hear people say that high share prices are “justified by lower interest rates”, what they are really saying is that the very low return expected from buying shares at high valuations looks acceptable relative to the very low return that you could get from owning bonds at very low yields. It does not mean you should expect the long run average return from equities if you buy them at high valuations, in fact you should probably expect to earn considerably less.

Valuing equities would be simple if we had just one payment and we knew with certainty its value in five years’ time but of course that is not the case. Whilst assumptions have to be made about future growth rates and terminal values, it is worth remembering that your returns as an equity investor come from income, plus growth, plus any change in valuation during your holding period. If you buy a stock on a 5% dividend yield, that grows its dividend at 3% and get no rerating, your return is 8%.

Conversely, if you buy a stock on a 1.5% dividend yield, even if it grows at 4% p.a. your return is 5.5% p.a. but if it just de-rated to 2% at the end of the five year period, your return is zero, i.e. that small de-rating is enough to wipe out all of the five years of 5.5%.

There are two lessons from this; 1) Investors often underestimate the extent to which their returns can be harmed by de-rating and 2)Re-rating is not a sustainable source of returns, once a share has rerated from a 4% yield to a 1% yield, there isn’t that much farther to go.

This has relevance for two trades that seem very popular at the moment[2]
  1. Switching out of the UK to US equities or global equities
Anyone making this switch needs to think carefully about the likely level of returns baked into US equities given their starting valuations are over 3x higher than their historic norm (higher than both 1929 and 2000), as the chart below shows.To get a sense of how extreme valuations have become after a decade of deranged monetary activism, the chart below shows the ratio of U.S. total equity market capitalisation to GDP. The present ratio is 2.63. The historical norm – not the low, the norm – is 0.78, about 70% below the current level.[3]
Graph

Source: The Speculative V by John Hussman, January 2020.

Just to stress this point, for those currently allocating to US equities, if valuations revert to long-run averages, you should expect to lose over two-thirds of your money (more if they fall below the long run average valuation).
Since valuations just reverting to their long-run average would imply a loss of 70%, I assume that those currently buying US equities must be making a forecast that the Federal Reserve will be able to hold valuations at the most extreme level in history forever. But even if they do manage to pull off something that has NEVER happened before, what is your likely return? Using the methodology above, the US equity market currently has a dividend yield of 1.5% and over the last two decades the trend growth rate in real GDP has been 1.6%. If we think nominal growth might be able to get to 4% and add the 1.5% dividend yield we would get to 5.5%. annual return. So, if the Fed can hold valuations at their all-time highs forever, you could eke out 5.5%, which some might feel is not too bad in a world of zero rates. But what is your risk from a slight derating?
In a recent interview John Hussman[4] stated that the US equity market currently yields 1.5% and that if it just moved back to a dividend yield of 2% (the median for the bubble years of 2000-2020), that would reduce returns by 5.6% p.a. thus wiping out your 5.5% (the figures we used in our de-rating example above). And try not to think about the level of losses that would be incurred if the market moved back to its long-run average dividend yield of 4%. Given these basic assumptions, now seems a strange time to be allocating to the US.
Given those probabilities, I personally wouldn’t be buying US equities. With the UK standing at the widest valuation discount to MSCI World Index for 50 years, I definitely wouldn’t be using UK equities to fund my purchase of US equities.
Graph

Source: RWC Partners, 31st December 2020.

    2. Switching out of Value into Growth funds[5].

As we have seen above, your annualised returns can be amplified by a re-rating over time whilst they can be damaged by a de-rating. However, it is not prudent assumption to expect re-rating to be a permanent source of returns since there is usually a lid on valuations. In fact, the most accurate forecasting models of long-run asset class returns usually assume some reversion to mean in valuations[6].
If a growth fund manager tells you that ten years ago his fund had a free cash flow yield of 7% whereas today it is 2.5%, he tells you two things. Firstly, that move has led to a return of 180% i.e. turned £100 into £280 and his total return should be considered in this context. Secondly, starting at 2.5%, that trick cannot be repeated, and it is, therefore, highly unlikely that future returns will be the same as past. Meanwhile when another value fund manager tells you that his average stock has a free cash flow yield of 10%, you should try to think in probabilistic terms about whether his stocks are likely to produce a better or worse return than the stocks on a 2.5% free cash flow yield. Try to ask yourself what growth rates you need to assume for the expensive stocks to produce a better return than the value stocks and how realistic that is in a world of 1.6% real GDP growth. How confident are you that those all-time high valuations for growth stocks will hold forever and consider what the returns will be given even a small de-rating. Think about how the value manager’s stocks returns could be amplified on just a small re-rating. Given all those facts, does the probability look good for switching from value to growth right now? Does a switch in the other direction actually make more sense from a probabilistic point of view?
Graph

Source:RWC Partners, 31st December 2020.

Conclusion
It has been shown that emotional decisions are often poor ones, especially when it comes to investing[7]. The narrative of the US market being full of exciting companies that can keep growing forever and of the Federal Reserve being able to hold all time valuations at these levels forever might seem an enticing one but how plausible is it? Trying to calculate expected returns using income, growth, change in valuation and probabilities on various outcomes might seem less exciting but historically it has been the more accurate one. Moreover, anyone adopting the latter methodology would struggle with the logic of selling UK to buy US or selling value to buy growth and would more likely be doing the opposite.

[1] https://acquirersmultiple.com/2018/08/michael-burry-risk-is-not-defined-by-volatility/

[2] Equity funds were the best-selling asset class in December 2020 with £2.5bn in net retail sales, buoyed by strong inflows into Global equity funds of £1.5bn. Funds investing in North America were the second most popular by region, taking in £504m.

[3] The Speculative V by John Hussman January 2020

[4] Superinvestors and the Art of Wordly Wisdom interview with John Hussman Jan 2021.

[5] ‘Meanwhile, the worst-selling Investment Association sector in December 2020 was UK Equity Income with an outflow of £501m, as the UK remained out of favour. Overall, UK funds saw net retail outflows of £845m’. Investment Week 4 Feb 2020.

[6] See, for instance, GMO, Research Affiliates or Hussman Advisors.

[7] See for instance ‘Do emotions overwhelm probability in decision making’ by Joe Wiggins April 2017.

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.
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