Effective Investor

Sparks

INTRODUCTION

I would stand and look out over the roofs of Paris and think, … All you have to do is write one true sentence. Write the truest sentence that you know. So finally I would write one true sentence, and then go on from there. … Up in that room I decided I would write one story about each thing that I knew about.

Ernest Hemingway, A Moveable Feast

Why is the South African stock market important?

First, it is classified as an emerging market. However, while the country shows emerging characteristics, its stock market is highly developed. Created in 1887, it is one of the oldest stock exchanges in the world and is the eighteenth largest in the world in terms of market capitalisation and trade. It is by far the largest of Africa’s 29 exchanges and accounts for over a third of the stocks listed on the continent. It is an integral part of the world-class financial infrastructure of the country, and South Africa was ranked first of 139 countries for its regulation of securities exchanges by the World Economic Forum in 2010.

Global emerging markets are evolving into developed markets, while frontier markets are becoming the new emerging markets. Understanding the South African market provides insight into the paths that these markets will follow in future. Similarly, the techniques highlighted in the book for dealing with volatility are applicable to similar markets elsewhere.

Second, South Africa is the newest member of the BRICS grouping. This gives it the role of Africa’s representative and it is of particular interest to China as a bridgehead to access this resource-rich continent.

Third, it is a gateway into Africa, both directly in terms of its highly developed financial, legal and banking infrastructure and indirectly, through the exposure of many of its top corporates to African countries.

Finally, it is an attractive market in its own right. It has been the third-best performing stock market in the world since 1900, and has weathered the great financial crisis with flying colours. While the investment lessons from the South African market outlined in this book are universal, understanding some of its peculiarities is also important. For example, some insight into the behaviour of the currency, the rand, is clearly critical in terms of any investment in this market, as well as in providing some understanding of other volatile emerging market currencies, and also because it is often treated as the most liquid proxy for these currencies, particularly during upheavals.

In addition, traditional macroeconomic approaches to investment in this market often don’t work because of the weak correspondence between the compositions of the economy and the market and the dominance of resources, a fact which is usually missed by analysts in developed countries.

A study of the South African market therefore has much wider implications and applications.

The idea of this book was born a couple of years ago, after I had spent twenty years in the stock market, and a client approached me for a presentation. They were planning a workshop for their less experienced analysts and the title was to be Things I Wish I Knew When I Started. After expanding the title to include … and Things I Wish I Was Less Certain About! I found that the process of searching through a huge, diffuse cloud of accumulated facts for what was truly important was both enjoyable and clarified my own thoughts. The idea of expanding the presentation into a book was born.*

I am also keenly sympathetic to the plight of individual investors. First, they are hobbled by psychological obstacles; this book will make them aware of these. Second, they are vulnerable to the guidance dispensed by their advisors. This guidance is often poor, either being plain wrong or being too generic for the specific context of the South African market. I hope that factual research on the actual behaviour of the South African stock market, research that is usually available only to investment professionals, will improve this situation.

Later, when I surveyed the books available, I was surprised to see that there wasn’t a single local book on investing which was based on research specific to the South African stock market. The purpose of this book is to fill that gap.

The aim of this book is not to be a textbook, or even to be comprehensive, but to provide you with the most important essentials – the key insights you should know about how the stock market works. Given the current convulsions in world markets, the value of these insights is higher than ever. I have therefore written only about the things that I know; in other important areas I have solicited contributing authors who are more expert than I.

One core principle has been a commitment not to dumb down any content, but to explain it with sufficient clarity to make its implications understandable to the average reader. There is no glossary. If unavoidable jargon is used, it will be explained when it first occurs, either in the text or in a footnote (use the index to find its first occurrence). Aside from this, the book is only loosely sequential so the chapters may be read in any order. Each chapter ends with a succinct and simple summary that crystallises the investment insights and conclusions. The aim is to make the book useful to both investment professionals and individual investors.

Unlike the promises in many populist investment books, this book won’t make you immensely wealthy quickly. It may not even make you immensely wealthy slowly. What it will do is explain the most important features of how the stock market works; guide you into forming realistic expectations; help you to avoid the most common pitfalls and evaluate investment information critically and show you how to reduce risk and enhance returns. It should save you money and time and I hope it provides new and practical insights, regardless of your investment experience.

* There were reprisals – the instigator was asked to be a guest contributor to this book.

PART ONE

THE FUNDAMENTALS

In the first part of this book we address the fundamentals of investment and the way things are supposed to work in theory – what the returns we seek consist of, the factors that influence these returns, the behaviour of these factors and their relative importance, how to value shares and the actual investment record of various assets.

In Chapter 1 we define returns and their components, and discover that over the long term company earnings are all-important. We therefore look at how earnings behave and ways of estimating them.

Chapter 2 examines the other elements that influence share prices, their relative importance, particularly expectations, and how to gauge them. Individual investors may wish to skim over some of the detail while extracting the key conclusions that are highlighted.

Chapter 3 explains what we mean by the market and highlights an important principle of how to beat it over the long term. It also discusses the relationship between shares and bonds and how to gauge their relative attractiveness.

How does one value shares? This is the topic of Chapter 4 and, after discussing how efficient the market is, we look at basic valuation methods and some of their hazards.

Chapter 5 is possibly the most useful in the book, showing the actual rewards, risk and behaviour of various assets in South Africa going back 109 years. The lessons here are implicit. This chapter will also be particularly helpful for advisors in dealing with their clients.

Chapter 6 emphasises the importance of time in investment.

These six chapters provide an essential grounding for all investors.

1

WHAT DRIVES RETURNS

An investment operation is one which upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Benjamin Graham

This book is about investing, not trading. Trading, because of its short-term nature, is intrinsically speculative according to Graham’s definition.

So what is investing? Investing is spending money now to receive more money back in the future. We also want it to be more money in real terms, i.e. after inflation. Normally we spend our money on assets. These could be equities (shares), bonds, fancy financial instruments, property or gold coins; we could also lend our money, for example, to a bank. (Equities is another word for shares – we will use the terms equities, shares and stocks interchangeably.) While we will touch on most of these asset classes, our focus will predominantly be on equities.

The principles in this chapter will usually be illustrated for the overall equity market, but these concepts are also applicable to individual shares.

TOTAL RETURNS

The money received from equities comes from price appreciation and dividends.

Companies distribute a portion of their earnings to shareholders in the form of dividends. In the words of Graham and Dodd, The primary purpose of a business corporation is to pay dividends to its owners. Dividends are normally expressed as cents per each share that has been issued. For example, if a company produces dividends of R9m and it has 3m shares in issue, its dividends are R3 or 300c per share. This is convenient because the price of a share is usually expressed in cents as well.

The dividend yield (DY) is calculated by dividing these cents per share by the share price, also in cents, and expressing the result as a percentage. This is analogous to an interest rate. For example, if you receive this annual dividend of 300c on a share and its share price is 10 000c, its dividend yield is 3%.

The total return from a share, expressed as a percentage, is the change in price (the capital gain or price return, also expressed as a percentage) plus dividend yield (the income return).

Total return = change in price + dividend yield

For example, say you buy a share at 10 000c. It then appreciates to 12 000c and the company pays a dividend of 300c. The capital gain is 20%, the dividend yield is 300c/10 000c × 100 = 3% and the total return is therefore 23%.

COMPONENTS OF RETURN

We can now break up the price return into two components – change in earnings and change in rating. Let’s first define these components.

Earnings are essentially the taxed profits that companies produce. They are also expressed as cents per each share that has been issued. For example, if a company produces taxed profits of R21m and it has 3m shares in issue, its earnings are R7 or 700c per share. For the overall stock market, earnings are the sum of all the listed companies’ earnings divided by the total number of shares in issue.

A share’s rating is a measure of how its earnings are valued, i.e. what price is attributed to its earnings. For example, two shares may each have earnings of 700c per share. However, one may be priced at 7 000c, i.e. the share is valued at a price which is 10 times its current earnings, while the other may be priced at 10 500c or 15 times its current earnings. Differences in ratings are caused by different expectations of future earnings growth, risk, the volatility of future earnings, inflation (and hence the valueless component of earnings), interest rates which, together with inflation, determine the real discount rate, as well as general sentiment and behavioural effects. We will discuss many of these aspects later.

Rating is usually expressed as the PE ratio, which is simply the price (per share) P divided by the earnings (per share) E. Although dividend yield and earnings yield (earnings divided by price or the reciprocal of PE) also indicate how a share is rated, when we speak of rating this will normally refer to PE.

We can now break up the price return as follows:

Price return = change in PE + change in earnings

So our previous formula for total return now has three components:

Total return = change in PE + change in earnings + dividend yield

These are the only three factors that determine returns*.

The relative importance of these three components of return changes, depending on the duration of the investment. The graph in Figure 1.1 shows their relative contribution to the returns from the overall stock market over different periods. The round markers represent annualised average returns over these periods.

Figure 1.1 Contributions to the ALSI’s compounded total return (1960 – 2008)

First, note the stability of the contribution from dividend yield. This averaged 3.1% p.a. over the periods shown. While this appears to be low, do not ignore dividends.

The power of dividends lies in the compounding of their reinvestment back into a share or the market.

Second, while the contribution of rating changes has been large over the last five years, it has been small over longer periods, averaging just –2.6% p.a. over all periods. Over the last 49 years the contribution of rating changes to returns has been negligible at – 0.5%, emphasising that over the long term returns tend to follow earnings only. If earnings growth is relatively stable over the long term, the corollary therefore is that returns should also be stable. This is borne out well by the data, with average annual returns over the past 10, 15, 20 and 49 years all lying between 13.8% p.a. and 18.4% p.a. Another effect is that the range of returns over longer periods diminishes. We will discuss this so-called time diversification of risk in Chapter 14.

The graph in Figure 1.2 shows the contribution of the three components to rolling 20-year returns. Since the data begins in 1960, the first points on this graph start in 1980.

Figure 1.2 Rolling 20-year components of the ALSI’s return

The contribution from earnings growth has been relatively stable over time, while that from rating changes underwent a structural change around 1994. Before that, rating changes tended to be negative and dividend yields high, while in recent years upward reratings have tended to support returns and compensate for a secular (i.e. long-term or structural) decline in dividend yield. The contribution from earnings growth has also increased since the mid-90s and has increased particularly strongly in the last few years.

IN THE LONG TERM, IT’S ONLY EARNINGS

We have seen that over very long periods, the contribution to total return from changes in PE is negligible and the contribution from dividend yield is relatively small. Therefore, long-term returns will be roughly equal to earnings growth:

Without dividend yield, return is simply change in price so change in price is roughly equal to change in earnings, implying that price and earnings will move together. This reveals one of the greatest truths in markets:

Over the long term, the single most fundamental driver of price is earnings and only earnings.

This results in the most fundamental picture of the behaviour of markets and the first of our 11 Great Investment Pictures. This next graph in Figure 1.3 shows the long-term price performance of the United States market, represented by Standard & Poor’s S&P 500 index, since 1871.

Great Investment Pictures #1 Price follows earnings

Figure 1.3 The United States market – price and earnings (S&P 500 index)

DATA SOURCE: ROBERT SHILLER, YALE

We have indexed the data to overlay the two lines by minimising the total absolute percentage difference between them.

Price has tracked earnings closely over the long term. Phases of poor performance and bear markets have tended to result from price running too far ahead of earnings and vice versa. The price movements around long-term earnings are secondary effects, attributable to shorter-term changes in rating.

The picture shows that the United States market’s price lagged earnings from 1974 and then began to accelerate from 1982, producing an almost two-decade long bull run, overshooting earnings from 1996 until its peak in 2000. The market price then followed the decline and subsequent recovery in earnings, with the gap almost closing, although earnings have since fallen.

Incidentally, over the long term, the United States market has exhibited two distinct phases. In the first phase, from 1871 to 1941, its average price appreciation was quite uninspiring at slightly less than 1.0% p.a., with the market rising by only 100% over these 70 years. In the next 66 years to the end of 2008, the market rose by a dramatically higher 7.1% p.a., appreciating by 10 000% over this period.

The fact that price follows earnings over the long term is universally true for all markets, including the South African market, as shown in the next graph of the market in Figure 1.4, represented by the Financial Times Stock Exchange/ Johannesburg Securities Exchange (FTSE/JSE) All Share index (ALSI) and its earnings since 1960.

Figure 1.4 The South African market – price and earnings (ALSI index)

We have indexed the data to overlay the two lines by minimising the total absolute percentage difference between them.

Again, price has tracked earnings closely and phases of strong bull and bear markets have tended to result from price deviating too strongly from the trend in earnings.

The first principle of long-term investing is therefore to select shares that will show good earnings growth. In the words of Warren Buffett, It is an inescapable fact that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do. Obviously, the longer this growth persists, the better. Very high growth rates, however, are difficult to sustain so there is often a trade-off between the level of growth and its duration. It is also an inescapable fact that most long-term earnings forecasts breach this principle. We will discuss this in Chapter 27 on style investing.

All the above principles apply to market sectors as well as individual shares.

ANOTHER WAY OF LOOKING AT IT

Without introducing anything new, we can regroup the three components of return as follows:

The fundamental return (Keynes termed this enterprise) is earnings growth plus dividend yield. For example, indefinitely long earnings growth of 10% p.a. accompanied by a dividend yield of 3% p.a. will result in a fundamental return of 13% p.a. (They should actually be multiplied but for small numbers the difference is small and we will keep it simple.) If we know these two numbers accurately, the calculated return is certain. Over the long term, dividend growth is approximately equal to earnings growth, so the return over the long term is simply average dividend yield plus dividend growth.

The judgemental return (Keynes’ speculation) comes from a change in rating. If a stock’s PE rises by 15%, the judgemental return is 15%. The total return in this example will therefore be 13% p.a. plus 15% p.a. or 28% p.a. Estimating the judgemental return requires the estimation of investors’ mood and is more difficult than estimating earnings and dividend yield (not that these are particularly easy).

To estimate the future return from an investment in the stock market, we have to estimate each of the original three components of return. First, let’s estimate future earnings growth.

EARNINGS GROWTH IS MEAN REVERTING

Extremely few companies have been able to show a high rate of uninterrupted growth for long periods of time. Remarkably few also of the large companies suffer ultimate extinction. For most, their history is one of vicissitudes, of ups and downs, with changes in their relative standing.

Benjamin Graham, Security Analysis, 1951

Sir Francis Galton discovered the statistical phenomenon of mean reversion over 100 years ago. The concept is simple – for example, tall parents tend to have shorter offspring and vice versa. This applies to many other physical characteristics such as IQ and happiness, and is also found in many economic and market quantities. Mean reversion therefore refers to a situation where some quantity fluctuates around an average value that is constant over the long term and serves as an anchor or central tendency. (The opposite of mean reverting is mean averting or trending, but this also cannot continue indefinitely.)

According to a fundamental tenet of economics and finance, corporate profits should be mean reverting when markets are competitive. The profitability of firms cannot increase indefinitely since any lucrative market niche will eventually attract competition, which will drive profits back down to some sustainable level. Conversely, profits cannot drop indefinitely either. Too much competition in a given industry will result in an inevitable shakeout, enabling a recovery in its financial health. Poorly performing firms may also attempt to poach managerial or technical talent from competitors in an attempt to raise profits. Not only is the theory of mean reversion of profitability a cornerstone of much of economics and finance, it is therefore also intuitive. But how does it hold up against the facts?

The answer is remarkably well. Fama and French¹ found that profitability – measured as earnings (before interest and extraordinary items, and after taxes) divided by book assets – has a very strong tendency to revert to the mean. In fact, they found that the rate of mean reversion was as high as 38% per year.

However, this basic result masks important nuances. Fama and French found that the rate of mean reversion is higher when profitability is far from its mean, in either direction. In other words, the further away a given firm’s profitability is from the average, the faster profitability will converge to the average. This pattern of mean reversion is not symmetric. Poorly performing firms tend to see their profits revert faster than above-average performers.

What causes this asymmetry in mean reversion? Possibly, when a firm’s profitability is low, managers fearing bankruptcy or a takeover have a strong incentive to reallocate assets to more productive uses and improve performance. This incentive is stronger the further profitability is below the average. Conversely, the higher a firm’s reported profitability is, the more competitors it will have, all vying for a share of its lucrative market. In addition, accounting conservatism may influence the reporting of profits. Under accounting rules in many countries, losses are generally reported quickly, but gains are spread over longer periods. This asymmetric treatment of gains and losses may explain why profitability reverts to the mean at a faster rate when it is particularly low.

Earnings follow a similar pattern. Changes in earnings often reverse from one year to the next and the tendency to do so is stronger for more extreme variations in earnings. Below-average earnings also revert faster to the mean than above-average earnings. The similarity with profitability patterns is not coincidental. The authors argue, Competitive forces produce mean reversion in profitability, which is then the source of predictable variation in earnings.

Neither profitability nor earnings follow a random walk. Both can be predicted to some extent, based on their mean-reverting tendency.

George Stigler, the 1982 economics Nobel laureate, best captured the critical importance of this behaviour: There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries.

TOP-DOWN ESTIMATES OF EARNINGS GROWTH

Aggregate earnings and dividends of companies listed on the JSE have outstripped inflation since 1960. The differential has been huge – beginning from a base of 100, inflation has risen to 5 500 over this period, while earnings have exceeded this by a factor of over five, reaching 31 300 and dividends grew to 22 500. The log scale on the graph in Figure 1.5 tends to underemphasise this.

Figure 1.5 The South African market’s earnings and dividends, GDP and inflation

Having seen that price tends to follow earnings over the long term, the fact that earnings have outstripped inflation suggests that share prices have also beaten inflation handily over this period. This has indeed been the case and we will discuss it in Chapter 5.

Although the earnings and dividends of the ALSI have outpaced inflation strongly since 1960, they are now 30% below gross domestic product (GDP), having generally lagged it, particularly since 1982. However, you should not expect the theoretical long-term equivalence between market earnings growth and GDP growth to hold in South Africa’s case for the following reasons:

Only 40 companies account for most or 85% of the ALSI, with mid caps and small caps (mid-sized and small companies) accounting for 13% and 2% respectively.

The ALSI is not a diversified sample of companies and has large survivorship bias. In other words, it always consists of above-average companies since the poorer ones tend to become smaller and eventually fall out of this market index.

Some of its largest companies, such as Anglo American, operate offshore and have a low dependence on the domestic economy.

Unlike GDP, nearly half of the ALSI consists of resource companies.

One could also argue that a strong economy can lead to a stronger currency, which would dilute offshore companies’ earnings when translated back into rand, resulting in a negative correlation** between the economy and a large portion of the stock market!

The ALSI does not reflect the composition of the economy at all, as shown in Table 1.1.

Table 1.1 Composition of the ALSI and GDP

SOURCE: SOUTH AFRICAN RESERVE BANK, ECONOMISTS’ ESTIMATES

In terms of its contribution to GDP, tourism has almost overtaken the total mining industry and is already 50% larger than the precious metals industries. In addition, the relationship has become even poorer in recent years, as shown in the graph in Figure 1.6.

Figure 1.6 Growth in ALSI earnings and nominal GDP

The deviation in 2000 was probably from the information technology stocks in the market. Since 2004 most of the difference is attributable to the resources boom. The structure of the ALSI can also change rapidly relative to GDP.

Macroeconomic forecasts of earnings growth are therefore less relevant to the South African equity market than in more developed countries where markets are more representative of the economy.

There are two ways of estimating earnings growth for a sector or the market as a whole – bottom-up or top-down. Bottom-up estimates take earnings forecasts for individual stocks and then aggregate them in the same way that the sector or market price index is created. Top-down estimates are made from macroeconomic forecasts for industry sectors or the country as a whole.

For example, for the industrial sector of the market we could take expected real GDP growth plus expected consumer price inflation (CPI) as an estimate of future nominal earnings growth. The graph in Figure 1.7 shows how this approach has compared with reality.

Figure 1.7 Simple top-down model for industrial earnings growth

Industrial earnings growth tends to follow the economic cycle most of the time, so turning points in the economic cycle are quite important. However, while directionally similar, the volatility of actual industrial earnings growth is substantially larger than that of nominal GDP, consistently overshooting it in both directions.

But we can improve the forecast. First, gross domestic expenditure (GDE) is more appropriate than GDP since the industrial index has a rand-hedge component of earnings of around 20% (compared with an estimated 65% for the whole market), so the major portion of this index is not strongly dependent on exports and imports. Also, producer price inflation (PPI) should be a better measure than CPI since the prices of raw industrial inputs are more relevant to industrial index earnings than household items. We also find that actual earnings growth lags this sum of GDE growth plus PPI and we can incorporate this lag in our model. Making these simple changes improves the relationship significantly, as shown in the graph in Figure 1.8.

Figure 1.8 More elaborate top-down model for industrial earnings growth

Unfortunately, this is still not good enough. For example, in the past when estimated top-down earnings growth was 20%, actual growth ranged anywhere from 5% p.a. to 35% p.a. The results are even poorer if we include financials by using the financial and industrial index (F&I) and worse still for the ALSI since the resource sector is even less amenable to this approach.

Additional reasons for the poor performance of top-down estimates are the following:

The market index incorporates acquisitive as well as organic growth.

Operating earnings are modified by items such as depreciation, gearing and tax.

GDP is influenced strongly by its agricultural component.

GDP includes many other factors in addition to company profits, such as remuneration and depreciation.

The top-down approach does not work sufficiently well in the South African market. Do not use it.

THE PREDICTIVE POWER OF THE YIELD CURVE

The stock market has predicted nine out of the last five recessions!

Paul Samuelson, 1966

First, let’s define a bond. It is a long-term debt security issued by governments, municipalities or corporations, which offers fixed interest payments (usually twice a year) for a period of longer than one year. Most bonds are traded on exchanges. The loan principal or par value of the bond is repayable on a fixed future date called the maturity date. The annual interest payment divided by the par value is equivalent to an interest rate and is called the yield (to maturity) of the bond. The advantage of investing in bonds is that your interest income is known (unlike share dividends) and there is a low risk of default on these payments. Their major disadvantages are that this income is fixed and may be eroded by inflation, and that interest income is taxed while dividend income is not. For more on bonds see Chapter 3 and Chapter 20.

A better method of estimating future growth is to use the yield curve. The yield curve is simply a graph of the interest rates or yields of similar-quality bonds of different maturities, plotted from the shortest to the longest maturity. The yield curve is available in financial magazines such as the Financial Mail, the JSE’s Yield-X website (http://www.yieldx.co.za/) or the Bond Exchange of South Africa (BESA).

If short-term yields are lower than long-term yields, i.e. the curve is upward sloping, then it is called a positive or normal yield curve. If short-term yields are higher than long-term yields, i.e. the line is downward sloping, then the curve is called negative or inverted. If there is little difference between the yields, the curve is called flat. An example of an inverted yield curve is shown in the graph in Figure 1.9.

A fancier name for this is the term structure of interest rates. Newspapers, the South African Reserve Bank and other financial institutions publish yield curve data.

In recessions, the yield required from long-maturity bonds tends to be high since investors are particularly risk averse and do not want to be locked into long-term situations, while yields on short-maturity bonds are low because the central bank usually cuts short rates to stimulate growth. This results in an upward-sloping yield curve. The positive slope therefore forecasts that the next phase in the economy will be one of recovery (normally accompanied by higher inflation). The predictive power of the short-term rate alone is also high. The converse situation occurs in expansions. A flat curve indicates that there are no strong views on either growth or inflation.

Figure 1.9 The yield curve

A forecast model of the economy can be constructed using the slope of the yield curve. We can measure its slope by the spread or the difference between interest rates at the long end and short end. The graph in Figure 1.10 shows this model for the United States.

Figure 1.10 United States GDP growth and the slope of the yield curve

The model, which uses the slope of the yield curve, coincides well with actual GDP growth four quarters later. Although they are not all shown here, there have been nine recessions since 1952. Negative yield spreads preceded all except the first three. An inverted yield curve² has preceded every recession since 1964. There was one notable inversion, from the third quarter of 1966 to the fourth quarter of 1966, which was not followed by a recession although this period was followed by a period of relatively slower GDP growth.

While inverted yield curves preceded all the post-1964 recessions, the initial lead time between the onset of the inversion and the beginning of recession varied between two and six quarters. From the time the yield curve inverts, it may stay inverted or return to an upward-sloping shape before the onset of the recession. Interestingly, for practical purposes the predictive power of the yield curve is much the same for 4, 8 or even 12 quarters ahead so it is quite robust.

The relationship between the yield curve and the economy is even stronger in South Africa, as shown in the graph in Figure 1.11.

Figure 1.11 South African GDP growth and the slope of the yield curve

The slope of the yield curve has anticipated changes in the South African business cycle by between three and eight quarters.

Earnings growth for companies, and hence the overall market, moves in tandem with the economic cycle and you would therefore expect the yield curve to anticipate the earnings growth of the market. It does. In the next graph in Figure 1.12 we plot the slope of the yield curve against earnings growth from the ALSI.

Changes in the yield curve’s slope lead market earnings growth by about 12 months.

Figure 1.12 The slope of the yield curve and ALSI earnings growth

Unlike GDP growth, all periods in which the yield curve became inverted turned out to precede a contraction in the market’s earnings growth. The yield curve is therefore an important tool in anticipating changes in earnings growth and consequently market cycles, since price ultimately tends to follow earnings.

An even better method than the top-down approach or the yield curve is to use bottom-up earnings forecasts and in later chapters we will discuss the individual company forecasts which comprise them. They also have their idiosyncrasies. For example, studies have found that analysts’ bottom-up forecasts are systematically more optimistic than the top-down forecasts made by strategists³.

Once you have a good forecast for earnings growth, forecasting dividend yield is then not too difficult – simply take the current dividend yield and escalate it by your anticipated rate of growth of earnings. This should be good enough as its contribution to the total return is usually relatively small.

For example, if you forecast long-term earnings growth for a share, sector or the overall market to be 10% p.a., it is currently on a dividend yield of 3% and you expect its PE to increase by 5% p.a., the approximate expected return is 10% p.a. + 5% p.a. + 3% p.a. = 18% p.a.

If you are a very long-term investor, there is no need to forecast rating (PE) since its contribution will be negligible. But if you are a shorter-term investor (say five years or less), then you need to estimate this component. We will discuss this in the next chapter.

INVESTMENT INSIGHTS

Three and only three factors determine returns. These are changes in earnings, changes in PE rating and dividend yield. Just add.

Over long periods of more than five years rating changes are negligible.

Over this longer term, the most important driver of share price and hence returns is earnings growth. Where earnings go, price will eventually follow.

Dividend yield is a relatively small component of returns, but the reinvestment of dividends can compound powerfully.

Historically, market earnings growth has outperformed inflation but lagged GDP growth for structural reasons.

Top-down forecasts of earnings growth for sectors and the overall market are poor.

The slope of the yield curve provides a good indication of economic turning points between three and eight quarters ahead.

Since market earnings growth largely coincides with the economic cycle, the yield curve also anticipates changes in market earnings growth, usually 12 months ahead.

The yield curve anticipates market cycles since price tends to follow earnings.

Also use bottom-up forecasts.

REFERENCES

1. Fama, E.F. and French, K.R., Forecasting Profitability and Earnings, The Journal of Business, 73(2), 2000.

2. Ang, A., Piazzesi, M. and Wei, M., What Does the Yield Curve Tell Us About GDP Growth?, NBER Working Paper Number 10672, 2004. www.nber.org/papers/w10672.

3. Masako N., Darrough, M.N. and Russell, T., A Positive Model of Earnings Forecasts: Top Down Versus Bottom Up, The Journal of Business, 75(1), 2002.

* All we are doing is breaking up price into two components by saying P = P / E × E = ‘PE’ × E and looking at the changes in these three items, i.e. ΔP = ΔPE + ΔE. Dividends can also be expressed as D = D / P × P = ‘DY’ × P. So the return, expressed as a percentage of the original share price P0, is:

Return (%) = [(P – P0 + D) / P0] × 100 = [(P – P0) / P0 × 100] + [D / P0 × 100] = ΔP (%) + DY (%) = ΔPE (%) + ΔE (%) + DY (%)

i.e. the change in rating plus the change in earnings (or earnings growth) plus the dividend yield. (Incidentally, we can also estimate a future price from Pfuture = PEfuture × Efuture if we want this explicitly.)

** Correlation is a measure of the strength of the relationship between two variables. It is usually represented by the symbol R or R². All you need to know is that a value of zero for R or R² means there is no relationship whatsoever, while a value of 1 indicates perfect correlation – the variables move in step.

2

WHAT DRIVES RATINGS

Over short horizons of a few years, changes in rating (i.e. PE) can be a significant contributor to returns. To estimate this component, we need first to identify the factors that determine PE.

THE USUAL SUSPECTS

Many factors, both quantifiable and difficult to quantify (such as sentiment), determine the ratings of shares, sectors and the market. But only a few account for most of these ratings. While the same factors tend to remain the important ones over time and in different markets, their relative importance changes, often significantly.

Table 2.1 shows the major drivers of the ALSI’s PE and the magnitude of their relative influence measured by their correlation with PE since 1970. Over shorter intervals and different historical periods their relative importance will change.

Table 2.1 Determinants of the ALSI’s PE (1970 – 2008)

Inflation is the strongest determinant of PE. A negative sign on the inflation correlation indicates that as inflation goes up, the market’s PE goes down.

Almost as influential is the exchange rate, emphasising that a large part of the market, predominantly the resources sector, is dependent on dollar-priced commodities.

The payout ratio (the percentage of earnings that a company pays out as dividends) has a large but negative correlation – as more earnings are paid out as dividends, the PE goes down. This implies that investors give higher ratings to so-called growth companies that reinvest earnings.

Interest rate changes have an impact on the market and its sectors; rising rates are bad and falling rates are good.

There is no correlation between the absolute level of interest rates and PE – it is changes in rates that are important. As interest rates move up, PEs move down. The fact that changes in interest rates have a lesser influence than changes in inflation is logical from a fundamental economic perspective. Interest rate changes are a lagging response to changes in inflation – if inflation never changed, interest rates would never have to change.

Future earnings growth (12 months ahead) is not the largest influence on the market as a whole, but inflation, the exchange rate and interest rates are common influences across all stocks, so the PEs of individual shares will be more strongly dependent on expected earnings growth and the payout ratio.

Similarly, although it does not appear in the table, there is an inverse relationship between a share’s volatility and its rating since high volatility implies high risk and higher risk makes it less attractive.

The high correlations of the next three resources factors in the table underline the influence of commodities on our market.

Also, the large correlations with United States factors emphasises the dependence of our market on global market trends and particularly those in the United States. One of the largest determinants of the South African market’s PE is simply the United States market’s PE, although the relationship between these markets’ PEs has varied. There was a very close correspondence from 1970 until 1992 but subsequently there have been periods where the two markets’ ratings have moved countercyclically, particularly at the time of the technology boom in the United States market and its associated peak in 2001. The South African market escaped the worst excesses of this bubble. Interestingly, the correlation of our market’s PE with United States interest rate changes is higher than its correlation with domestic interest rate changes, and its correlation with United States earnings growth is comparable in magnitude to its correlation with local earnings growth.

Using forecasts of the future levels of these variables rather than their current levels provides stronger relationships, but the improvement is too small to justify the effort of forecasting these variables. The exceptions are earnings growth and, to a much lesser extent, inflation. Also, there is little historical data on expectations so one often has to use actual levels and assume they were forecast with perfect accuracy, an heroic and clearly wrong assumption.

Let’s delve into more detail on the influence on ratings of future earnings growth, inflation, interest rates and other markets.

FUTURE EARNINGS GROWTH

The graph in Figure 2.1 shows the earnings growth cycle of the market.

Figure 2.1 The ALSI’s earnings growth cycle

Average real (i.e. after inflation) earnings growth over the long term has been 3.6% p.a. The real earnings growth cycle has been fairly consistent in terms of the limits of its range and also in the length of its phases, with the average cycle (one upswing and downswing) since 1970 lasting 38 months or just over three years.

As shown in Table 2.1, expected earnings growth is a determinant of historical (also called current or trailing) PE. How far ahead does the market look in terms of its expectations of earnings growth and does it have different horizons for different sectors? Since there is insufficient data on what earnings expectations were in the past, we assume perfect foresight.

The graph in Figure 2.2 shows the correlation between historical PE and earnings growth at various times in the future. We have used nominal earnings growth since 1980. (Although using real earnings growth achieves higher correlations, the patterns are essentially unchanged.)

The ALSI and its three major sectors correlate with future earnings growth to different degrees and they look forward by different periods. But in all cases the current level of earnings growth (i.e. growth zero months ahead) does not influence their historical PEs in the slightest. In fact, there is a negative correlation between current earnings growth and current rating.

Figure 2.2 Correlation between historical PE and subsequent earnings growth

A company or sector’s recent earnings growth is quite irrelevant to its PE since the market is valuing it on future, not past, growth.

Earnings growth begins to influence rating positively between three and ten months ahead, and correlation peaks over a year ahead. This correlation then declines and the market no longer looks at growth further than a couple of years away, depending on the sector.

The ALSI begins to look ahead at five months (i.e. where the correlation becomes positive) and reaches its peak correlation at 23 months. It has a relatively flat plateau between 12 and 36 months, indicating that it weights each of these three years of forecasts approximately equally, after which the correlation declines, reaching zero at 44 months. The market therefore does not look at earnings forecasts for a fourth year. There is good reason for this myopic behaviour, as we will see later, and it means we do not need to spend time forecasting further than three years. Even the number of third-year forecasts is substantially less than one-year and two-year estimates.

The financial sector looks further into the future – it has a longer plateau than the ALSI and stops looking ahead only at 57 months. Conversely, the resources sector behaves in a more short-term fashion, peaking at 14 months and declining rapidly thereafter, reaching a zero correlation after only 32 months. The industrial market has a far lower correlation with future earnings growth. Its rating shows two peaks in correlation, at 12 and 33 months ahead. This may be indicative of divisions within the broad industrial category. For example, the top three constituents of the industrial index, accounting for over half of its market capitalisation, are SAB, MTN and Richemont, suggesting a strong rand-hedge/non-hedge division within industrials. The industrial sector does not look beyond 38