Can value investing
PAY DIVIDENDS?
We investors are a strange bunch! Small, eminently predictable emotional factors sway our supposedly iron logic and encourage us to feel overly optimistic. Study after study has concluded that sunny days for instance produce better returns from investing in shares compared to dismal, rainy days. Spring it seems is also a good time to start investing even if other stockmarket lore suggests that you should start selling at the end of May! Perhaps our greatest weakness is to give priority to the recent short term whereas as every sensible piece of analysis suggests that the iron rule of the long term is much more powerful i.e. everything including stockmarkets mean-reverts eventually, which implies that if something looks expensive today, it probably is and will almost certainly fall in price at some point in the future.
I mention all these boring behavioural biases because I sniff an element of complacency creeping into the world of investing as we start Spring 2011. That caution shouldn’t be confused with pessimism though - by and large I share the growing sense of confidence that the global economy is starting a sustained recovery, even if we in the UK are mired in consumer despondency inspired by our belt-tightening government. Countries like China are struggling for instance to slow down their growth rates and resulting inflationary impulses and even the US housing market – the great engine of global growth – is showing very tentative signs of recovering in a few isolated places as employment growth picks up stateside. All of this big macro-economic stuff is to the good and should encourage investors to look askance at the supposedly lower risk virtues of gilts and bonds.
But we need to remember that stock markets are essentially forecasting machines where returns are built around future expectations of growth, balanced by the constantly evolving and mutating perception of risk. And in that delicate balancing act between the here and now, and forecasts for the future, we need to be hugely careful about giving too much priority to recent trends and positive data, ignoring the ever present risks.
As I look out upon the global stock markets I sense a growing legion of risks, none of which need dwelling on for any great length of time in this article. Everyone seems to be talking about inflation and the threat of higher oil prices yet a much smaller number of commentators are surely correct to be worrying about debt levels, which are still at elevated levels even in the private sector. Talk to investors in Southern Europe and they are terrified by the threat of bond vigilantes picking on their sun kissed economy while investor’s in the Middle East worry incessantly about geopolitical risk and Arab Springs.
Add up all these factors and you can understand why so many hedge fund managers are still wary about the possible risks to growth - they scrutinise all manner of key metrics and measures such as volatility, or container shipping rates looking for tell tale signals of a looming crisis.
Back in the real world populated by humble investors like you and I, we can’t afford to spend all our time glued to Bloomberg screens, scrutinising key metrics for global growth stats or oil price trends. We have to ‘make do’, by building investment portfolios around simple common sense, our gut and an inkling of what works for us. In this real world, investing is all about managing risk and return and in my humble opinion most ordinary punters are better off ignoring all the chatter of markets and focusing instead on two simple ideas that have worked time and time again.
The first idea is to buy a stock, market or asset class cheap relative to its financial soundness and growth prospects – study after study has shown that this idea of what’s called value investing absolutely works in controlling risk and increasing returns. The other idea is even simpler – buy cheap stocks that produce a constant stream of regular dividend cheques. This concept of focusing on the income from holding risky assets such as equities has also been tested to destruction and has been shown to produce the greatest part of total returns from investing in risky equities over the last hundred years. It’s also in my humble opinion, the very best way of riding through volatile markets and controlling long term risk.
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Dividends matter!
Talk to many institutional fund managers in the UK and they’ll confess that dividends really, really matter. The success of a dividend based investment strategy rests on a huge range of factors – the dividend payout itself, the rating attached to a high yielder and the stable growth in the dividend payout over time – but it’s the reinvestment of these dividend payouts that really makes the huge difference over time. The hard spade work on this analysis comes from the London Business School Professors Elroy Dimson, Paul Marsh and Mike Staunton – featured regularly in their Credit Suisse Global Investment Returns Yearbooks.
According to Dimson and his colleagues at LBS "the dividend yield has been the dominant factor historically "adding that" the longer the investment horizon, the more important is dividend income". But this LBS study also reminds us that the actual dividend yield itself is much less important than reinvesting those dividends. Looking at the 109 years since 1900 Dimson et al suggest that the average real capital gain in just stocks plus the dividend payout is about 1.7% per annum (an initial $1000 would have grown six fold), but over the same period dividends reinvested would have produced a total return of 6% per annum (or a total gain of 582 times the original $1000). Dividend reinvestment really matters and luckily most big progressive dividend payers have their own easy to use dividend reinvestment plans.
Yet the power of dividends in volatile equity markets rests on much more than just the reinvestment of those dividends. There is some evidence that a strategy of buying the right kind of dividend payers (progressive dividend payers with a decent balance sheet) will actually deliver better returns in and of itself i.e the market itself tends to prioritise the attractions of certain dividend payers and awards their shares a premium rating.
The reason for this market preference is obvious in retrospect – dividends are easy to calculate and involve simple, hard numbers made in regular payments. But dividends also tend to be much more stable over time compared to earnings – annual earnings growth has historically been 2.5 times more volatile than dividend growth according to French Bank SocGen – while the discipline of making the regular dividend payout encourages a more focussed management, determined to conserve the financial resources of the firm. As Andrew Lapthorne, an analyst at SocGen reminds us "the retention of a too high proportion of earnings can encourage unnecessary mergers and acquisition (and often wasteful) investment in the pursuit of higher earnings growth". Dividends by contrast are boring and steady – using long term data from the US stock market, rival French bank BNP Paribas recently produced research that suggested that the dividend from investing in US equities has not only risen consistently faster than inflation but has increased by a fairly steady 1.4% per annum in compound annual terms – an extra 1.4% every year, compounded makes a huge difference to returns data.
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But any paean to dividends also needs to be tempered by one sobering assessment – the importance of dividends varies hugely during different decades. The proof of this comes from analysis conducted by British bank BarCap – their analysis suggests that in recent years dividends have mattered much less. The bank’s annual Equity Gilt study recently concluded that the"contribution of dividend income to total UK equity returns fell to an alltime low in 2000, at the peak of the bubble, as payout ratios drifted down and investors focussed on the rampant price gains delivered by soaring valuations. At the margin, changes in the UK tax treatment of dividends for pension funds in 1997 reduced investor’s preference for dividend income, whilst changes in corporate taxation had much the same effect in the late 1980s in the US".
The BarCap analysis has one other crucial observation worth noting in passing – dividends are a good hedge against inflation i.e they tend to increase with inflation. A bank analysis paper observes that "Annual changes in dividends display a moderately positive correlation with inflation, averaging 38% over the 1950-2004 period in the UK and 26% in the US. When changes in dividends and inflation are considered over longer periods of time, the correlation improves, as would be expected from a volatile series. Over 5 year periods, the correlation is 54% in the UK and 52% in the US, whilst over 10 years the correlation is 56% in the UK and 70% in the US".
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The value premium
Many investors who choose to focus on dividends are also temperamentally drawn to a related but distinct idea – investing in cheap stocks based on solid fundamentals. The resulting ‘philosophy’ is called value investing and I think it’s single best way of controlling risks within your portfolio of risky assets such as equities. Pick a company or market trading below the sum value of its parts, for instance, and you are instantly buying yourself a ‘margin of safety’ that should be able to protect in you stormy weather, when volatility suddenly spikes.
The most eloquent recent statement for this idea of investing in cheapo stocks comes from Charles Lahr, global equity portfolio manager with Pimco. In a smashing little paper on value investing subtitled "Human Nature and the Last Great Anomaly" Charles spins through the mountain of evidence which suggests that buying a stock based on decent fundamentals was, and remains, a cracking idea. He estimates that the annualised premium for investing in value stocks over the period 2000 to 2010 currently stands at about 0.6% per annum globally, only 0.19% for the US, but 1.97% for emerging markets and a whopping 2.34% for Japan. But the decade’s long numbers hide some big annual variations- picking stocks that looked expensive because of their great profits growth trounced these cheapo value stocks in 2001, 2002, 2009 and 2010. Looking forward into 2011 and beyond he now reckons that "the outlook is quite good, mainly because the elements of human behaviour that created and support the value premium haven’t changed. Despite the substantial changes in the global economy that we’ve seen due to the financial crisis and that we expect to persist over a longer horizon, investor behaviour continues to fuel this phenomenon". Lahr concludes by admitting that "Value investing isn’t easy, and it’s not suited for most. It’s not glamorous in any way, shape or form - and this is exactly why the anomaly will likely continue".
Lahr is far from being the only investor to favour the idea of investing in good quality ‘cheap’ stocks. Back in the 1990s US academics Dr. Kenneth French and Dr. Eugene Fama looked at data on the entire universe of US stocks for the period 1964-1996 and found that small cap stocks that were also good ‘value’ produced returns of 20.88% compared to ‘poor value’ (growth) small caps which gave just 13.9%. Likewise also for larger companies that were good ‘value’ – they returned 15.8% compared to 11.7% for non-value peers. Their bottom line? Value stocks and small cap stocks that are less profitable than faster growing equivalent stocks produce greater share price returns! Analysts from index tracking firm Dimensional summed up this commonly accepted wisdom thus – "Everything we have learned about expected returns in the equity markets can be summarised in three dimensions. The first is that stocks are riskier than bonds and have greater expected returns. Relative performance among stocks is largely driven by the two other dimensions: small/large and value/growth. Many economists believe small cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk.
The here and now!
I’m absolutely convinced that as we enter a more turbulent but hopefully confident market over the next one to three years, the best protection for private investors is to be careful, diligent and cautious. Don’t overpay for anything and always look for ‘stuff’ that’s cheap but of decent quality. That means keeping a constant eye on decent stocks paying a dividend and also tracking down companies and markets that look cheap based on their fundamentals.
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