INVESTING’S ANSWER TO GRAVITY
In long run, valuation is key for predicting long-term returns, Tom Bradley writes.
We can’t help it. It’s human nature. Our view of how our investments will do in the future is influenced by how they’ve done in the recent past and what the headlines are telling us today. Unfortunately, both factors are poor predictors of what returns will be.
Extrapolating past returns is easy to do, but there’s no evidence that it works. There’s a reason why ETFs and mutual funds carry a warning label — “Past performance does not guarantee future results.”
As for the media, what’s in the spotlight is always interesting, but not always important when it comes to your portfolio.
For instance, while Trump, North Korea and Brexit dominate the airwaves, there are hundreds of other factors that will have a bigger impact on longterm returns.
The most reliable factor in determining what returns will be is the starting point. Specifically, the price you pay for an asset, or what’s referred to as valuation. Are you buying at Costco where bargains abound, or the Apple Store where nothing is on sale?
Over longer periods, valuation is the closest thing to gravity that investors have. Stock prices will eventually reflect the value of the underlying companies. But to be clear, valuation is useless in predicting the market’s direction in the next quarter, year or even two years. Stocks can stay cheap or expensive for extended periods.
So, what should you expect from your portfolio over the next five years?
For fixed income investments, the current starting point is not good. Safety is expensive. I say that because the most reliable predictor of bond returns is the current yield, and the Canadian bond market, which includes government and corporate bonds, is yielding just two per cent. As interest rates fluctuate, there will be short spurts of good returns, but you should count on core fixed income securities earning in the neighbourhood of one to three per cent.
The equation for stock returns is also simple. It’s the sum of three things: dividends, profit growth and the change in valuation. Unfortunately, stocks are much harder to call because the inputs are far less certain.
The first one is the easiest. Based on current yields, you can expect dividends to contribute two to three per cent each year to market returns.
Corporate profits have typically grown at six per cent, but I believe a more sustainable pace is three to four. The short-term outlook is good with the global economy picking up, but we’re entering an uneasy transition. We’re going from being debt fuelled to debt impaired. From being driven by baby boomers to supporting them. And from rising corporatism to more populism.
The biggest swing factor of the three, however, is valuation. What investors are willing to pay for profits can vary wildly. When I started my career in the early 1980s, high quality stocks traded at single digit price-to-earnings ratios. In late 1990s, those same companies garnered multiples in the thirties and beyond.
Today, P/E’s are in the mid to high teens, which is closer to historical averages, although after eight years of good markets, many analysts (including myself ) believe they’re at the high end. Some say stocks are downright expensive. Suffice to say, this variable will more likely moderate returns than boost them, as it has since 2009.
When we add it all up, we’re looking at an annualized return for stocks of four to six per cent.
When we combine bonds and stocks, the expected return for a balanced portfolio is in the range of three to five per cent. In comparison to the last five years, that doesn’t sound very exciting and you might ask, should I make some changes?
While every situation is different, in general the answer is no. The projections are well above inflation and the order of returns is perfectly normal — i.e. stocks beating bonds.
Rather, you should stick to the asset mix in your investment plan, make sure you’re not above your target for higher risk assets (high-yield bonds and stocks) and be patient. There’s too much capital chasing too few opportunities right now, but it won’t always be that way. You’re playing the long game. Financial Post Tom Bradley is President of Steadyhand Investment Funds, a company that offers individual investors lowfee investment funds and clear-cut advice.