March 7, 2019

2018 saw the passing of a giant in the fund management industry, John Bogle of The Vanguard Group, who was seen as the father of passive investing. He had many interesting insights into the investment industry, one of which was to break down investment returns into constituent parts (back in the June 2013 issue of CFA Institute publication). This idea resonated with us as a useful academic exercise to help investors understand where their returns are generated by different investment strategies. It was also interesting that in the opening paragraph he says: “History shows that the long-term returns of stock markets will reflect intrinsic values – a virtual certainty. But short-term variations in that relationship are equally certain, and they can endure even over decades”. Perhaps this is only the more pertinent nearly 6 years further into the current bull market.

The theory is this; Investment returns can be broken down into capital return (an increase in the share price) and dividend yield. The capital return can in turn be broken down into two parts: a growth in earnings (i.e. assuming the PE multiple stays the same, the share price will increase to reflect the increased earnings); and an expansion of the PE multiple (i.e. even if the earnings remain the same, the share price will increase in line with the change in the PE multiple). Bogle shares a study of US stock market returns by decade from 1900 to 2010, and a few points are interesting to note. The first is that nearly half of all returns over the 110-year period come from the dividend yield (4.5% of 9.2%) with almost all the rest coming from growth in earnings. The impact of the changing PE multiple (what Bogle calls the “speculative return”) is essentially 0%. This is, of course, what you would expect over such a long study. PE multiples fluctuate over time but cannot move in the same direction forever. Note, however, that in each individual decade, the impact of the speculative return is significant, and often larger than either of the other two return elements.

The speculative return reflects a change in sentiment over the period and is inherently difficult to predict. That said, in all but two of the eleven decades, low starting valuations resulted in a positive speculative return (i.e. in years when the starting PE was lower than 15x and the dividend yield was larger than 3.5%, then a positive speculative return ensued). The two decades in which this wasn’t the case were the 1990s (where starting valuations of 15.2x and 3.2% would predict a slightly negative speculative return, but the tech bubble at the end of the period resulted in rapid multiple expansion); and the 1910s (where starting valuations of 13.6x and 4.3% would predict a positive speculative return, but WWI resulted in falling share prices).

Active investors aren’t constrained by overall market valuations and can manipulate their portfolio to take advantage of Bogle’s observations. Companies’ earnings multiples and dividend yields are known – investment decisions can be made on the basis of valuation. Looking at the empirical evidence, these same valuation metrics also provide an investor with the best possible chance of benefitting from a positive speculative return. What’s more, by manipulating the portfolio over time (by selling companies where valuation metrics deteriorate, and buying companies with favourable metrics), it is possible to maintain a portfolio with advantageous valuation characteristics, so positive speculative returns can persist over time.

Managers should also look to increase the probability of benefitting from earnings growth. There are two ways of doing this. Either by buying companies with depressed earnings (where “growth” is effectively a reversion to mean) or by buying companies that look set to benefit from strong market positions and attractive product offerings. Kennox follows the first of these approaches as depressed earnings are usually coupled with low valuation metrics (i.e. we can have our cake and eat it), whereas the second approach is usually associated with higher valuation metrics. As such, growth-based stock selectors must realise strong profit increases to avoid being diluted by a lower dividend yield, and over time, a lower speculative return.

We are writing this at a time when, for the best part of a decade, value-based approaches have underperformed, and speculative returns have favoured more expensive stocks rather than those with lower valuation metrics. This brings us back to Bogle’s opening remark, that it is not impossible for short-term variations to endure for a decade or more, but that long-term returns reflect intrinsic value is a virtual certainty. We most heartedly agree.

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