Equity returns – time to go back to the basics

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By Shaun le Roux

The markets are difficult. As a result of the tricky economic backdrop of a struggling US economy and spiralling global inflationary pressures, which hit developing countries like SA hardest, most global equity markets have struggled over the last seven months. About the only ray of sunshine within equities internationally has been Resource stocks, which have delivered stellar returns and outperformed the broader market by a huge margin. As you know, the JSE is very top-heavy in large cap miners and as a result has continued to perform well, currently trading around all-time highs.

Commodity shares have been doing well because commodity prices have been going up. Are Resources still going to be the place to be invested in over the next few months? Well, it all depends on whether commodity prices keep going up. We don’t have a clue as to whether this will be the case but are not sure that current investor obsession with chasing asset price increases in what is clearly the hottest part of the market is appropriate, or for that matter necessary.

We think many equity investors have lost sight of the long-term rationale for investing in equities as an asset class. As we have demonstrated on numerous occasions, the bulk of equity market returns over time comes from dividends, and the compounding thereof.

Refer to the graph below. It compares the returns that would have been achieved by an investment in the JSE where dividends are reinvested versus what you would have enjoyed from share price growth alone. In this case we have compared the two strategies over thirty years, an appropriate time period for long-term wealth creation.

R100 invested in February 1978 would be worth R42 940 in February 2008 if dividends were reinvested, while a R100 investment that was exposed only to index price appreciation would be worth R13 425 as at February 2008. In other words, over a thirty-year period, 69% of the total return in an equity market can be attributed to the receipt of dividends, reinvestment thereof and the power of compounding.

This is exactly why equities are such an important tool in long-term wealth creation and the vital player in the battle against inflation eating into your retirement nest egg. If you invest in companies that pay healthy dividends, companies that manage to grow such dividends ahead of inflation over long periods and then re-invest these dividends back into such companies, you have discovered the holy grail of investing and long-term wealth creation.

This is why the current market obsession with rising commodity prices is concerning. When prices are low, as most commodity prices were in real terms at the start of the decade, it is more appropriate to be allocating capital to an under valued asset class. At current levels few people can make the contention that commodities are under valued. Hence, aggressive investment in commodities today encompasses a belief that prices will continue to rise. They may, and many people are betting it, but it is worth noting that a reasonable proportion of recent price appreciation has happened just because prices are going up, thereby drawing in the money that always chases what is hot. It is worth pointing out that the dividend yield differential between Anglo (1.8%) and Standard Bank (4.4%) is the largest it has ever been, with twenty six years of history to refer to. This differential implies a substantial proportional increase in the Anglo dividend in the years ahead.

The good news is that dividend yields on the broader domestic stock market, with the exception of Resources, have increased substantially. We believe that current market conditions provide an excellent opportunity to invest in quality, high dividend-paying companies whose dividends will continue to grow from these levels. You can invest today in a portfolio of such shares where dividend yields are 5% plus and long-term growth prospects are good. We don’t know whether such a portfolio will outperform the market over the short term but feel comfortable that the riskreturn characteristics of such a portfolio are particularly attractive for those prepared to take a longer-term view. The current bearish sentiment regarding the SA economy opens the door for equity investors who understand the basics of superior long-term investment returns – dividends and compounding.


Source: Shaun le Roux, Alphen Asset Management, May 12, 2008.


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