Last week Neal Foundly set out his slightly pessimistic view on equities. You can read his blog here.
In our recent investment management committee meeting Neal’s equity score was pretty negative at -3. His was the lowest score of all the committee members, the highest vote being +1.
We like debate and we see a range of views in our meetings. We challenge each other’s views and then together we hopefully come to more rounded conclusions.
Our scoring system is very mathematical. Over the very long term, we expect equities to return around 10% pa if history is any guide. When looking at prospects over 18 months, if we still expect 10% pa our score would be neutral. If we thought shares would underperform that by 50% we would give it a -5 score. If we thought they would outperform by 50% we give it a +5 score.
All committee members give their own scores and from that we work out an overall. Neal’s score implies only 7% pa returns over 18 months, whilst the +1 score would imply 11% pa. My own score was neutral (10% pa), and in the end the committee gave a -1 score (9% pa).
Of course this is an inexact (non) science but both of us based our scores on rational decisions.
Inflation, productivity and growth
I don’t disagree with most of Neal’s arguments, I just disagree with the conclusions.
Neal’s arguments included the fact that he thinks inflation is going to be lower than the long term trend, and GDP growth is also going to be lower. I agree on both counts. Productivity is also currently low and this is where we have slightly different views.
Neal included the below table in his blog showing how, adding all those factors together, he gets to his 7% pa and how this contrasts with the long term:
This is very logical but the one area I disagree slightly is productivity. It is low at present but there are signs it is starting to rise.
I also believe the apparently low productivity in the UK is partly a measurement issue. Productivity is very easy to measure in a manufacturing based economy. You just count the number of widgets produced.
In a serviced based economy like ours, it’s much more difficult. How do you measure MY productivity, for example? I haven’t made ANY widgets yet today…
Productivity could therefore be higher in the UK than we think. I would also point out that the UK market makes much of its earnings from overseas, so we need to look at global rather than UK figures.
The other reason I am more bullish than Neal is valuation.
The chart below shows our own in house indicator of equity valuations. This combines things like price/earnings ratios and price/book ratios, and a couple more, to give a composite score.
We display this like an old fashioned graphic equaliser. The green bar for each region shows the current value, and the black area the full historic range. The higher the green “fader” the more expensive the market, the further down the “cheaper” it is:
Underneath the chart you can see the average historic returns from each market over five years when our indicator was at its current valuation in the past. Looking at this alone you might think we could expect a lot more than 10% pa.
However, of course this is only an average. The score is taken from data such as the chart below, which shows the price/earnings of the UK market compared to subsequent five year return. Each dot represents a different five year period. There is a strong relationship between the PE of the market at the start of the period and the returns you get over that period:
You tend to get a high return when the PE is low, and a low return when the PE is high. I’ve circled the chart roughly where the PE is right now – somewhere in the middle. When the PE is around where it is now there is less of a clear pattern, in fact the range of returns has been somewhere between plus 20% and minus 10% over five years!
Where we agree…
Like Neal, I have concerns about the global economy. Profits aren’t growing very much in many of the main markets including the UK, and Neal is right to be concerned about dividend levels. I would therefore expect returns to be towards the lower end of the range, especially if we’re just looking at the FTSE 100 for example.
However, we don’t just invest in the UK and we don’t just invest in the main market in the UK. I am much more optimistic about smaller companies where we are seeing strong profit growth, and cheaper valuations than the FTSE 100.
I also think Japan, which is valued way below its long term average and is currently experiencing strong profit growth, looks a good prospect right now.
By tilting our portfolio away from the less attractive areas and towards those which we think have greater prospects, I believe we can still achieve some decent returns.
At the end of the day, it is the real return that matters – essentially by how much do returns exceed inflation.
If Neal is right that we get 7% over the next 18 months, with inflation currently at zero equities would give a pretty good real return. If we assume it averages 1% over that period we get a real return of 6% pa. That is bang in line with historic average real returns.
If we scored on real returns rather than nominal, perhaps Neal would also have given a neutral score.
The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.