These days you can count yourself lucky if you pick up a newspaper and do not find some pundit’s article about the European sovereign debt crisis and suggestions of how to fix it; not to mention endless predictions about the Chinese economy and the US budget deficits....and the list goes on and on.
Although some of these articles portray the immense knowledge and understanding that certain individuals have about these issues, unless you are George Soros or Ray Dalio, your chances of successfully adjusting your allocation between stocks, bonds and cash based on news flow around macro issues might prove less than successful.
One of the very few economic indicators, in our view, that should influence your asset allocation decisions is interest rates, and more the directional changes than the actual number. The other factors, as mentioned above, makes for interesting conversations, but is fairly useless when it comes to picking stocks or allocating between asset classes. The prime lending rate that is determined by the repo rate as set by the Reserve Bank is the price of money that in turn influences the prices of all the other asset classes.
In Graph 1 the relationship between the rate of change in the earnings yield (inverse of the PE) of Industrial stocks and the rate of change in South African interest rates is quite evident. We can see that there have been quite a few times in the past where the earnings yield of industrial companies have increased by 20% to 40%, which translates into a material de-rating in the price-to-earnings multiple of these stocks.
Why is this important? When measured over long periods of time, the return from stocks is equal to the growth in profits, plus the dividend yield, plus the change in the rating over the holding period. Over many decades, the value add from this rating change provides very little to returns, but over short periods, can have a meaningful impact on stock returns. Interestingly the PE changes of the market mostly coincide with the changes in interest rates, and if there is one certainty in life, it is the fact that interest rates are cyclical.
The best proxy for the growth in profits that we should expect from industrial companies is Nominal GDP growth, or in the second graph, we have used Personal Consumption Expenditure (nominal terms), as reported in the South African National Accounts. Although profit growth tends to be more volatile over shorter periods, the average since 1961 has been 12.3% per annum, against the 13.1% growth in Personal Consumption Expenditure. It is important to note that growth in Personal Consumption Expenditure is also exactly the same as the growth in Personal Disposable Income since 1961.
If Personal Consumption Expenditure can grow at 10%, which assumes 5% Inflation and real growth of 5%, we can assume that profits from industrial companies can grow at the same rate over the next few years. This return plus a dividend yield of roughly 3% can deliver a 44% compounded nominal return over the next three years, if we assume no changes in the price-to-earnings ratio from current levels.
If we look again at the first graph though, we can see that any upward move in interest rates should translate, with a slight time lag, into at least a similar upward adjustment to the earnings yield, which means a de-rating in the industrial universe’s PE. Depending on how large the interest rate adjustment is, this could have a significant impact on real returns from industrial stocks over the next few years. In the event that interest rates rise by 200 basis points over the next two to three years, around half of the total returns mentioned in the previous paragraph could be wiped out. This leaves a compounded annual growth rate of roughly 4%, in nominal terms, assuming the de-rating only takes us to an average rating. As we all know though, the rating adjustment swings between extreme lows and extreme highs in order to generate an average and thus the 4% nominal returns that we mentioned, could be optimistic.
Two final thoughts: Firstly, nothing beats the returns achieved by investing in good, and surprisingly often, smaller companies, after diligent homework. The best strategy with these companies is generally to leave them and let the returns compound over many years. This is well illustrated with the Industrial Index that has provided a compounded annualised real return of almost 18% since the market bottom in 2003, despite the market-crash in 2008.
Secondly, while we ascribe most returns to stock selection, we do believe that value can be added by diligently allocating between stocks, listed property, cash and bonds as the relative valuations change. The best indicator in this regard is the direction of interest rates. Monitoring the rating adjustments relative to interest rates is a good indicator of mispricings in the market. Our view is that the re-rating of industrial stocks since the beginning of 2009 has been predominantly driven by the decline in interest rates over the same period. Interest rates are possibly at their low point in this cycle – real interest rates are the lowest they have been since 1988. In the event that interest rates move higher from current levels, significant growth in profits would be required to sustain attractive real returns from industrial companies. This being more than we think is achievable in the long run.
REF : Neels van Schaik - PSG ASSET MANAGEMENT
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