Why shares are an investment in the future

Dominick McCormick argues that shares, not bonds, should be the core of long-term portfolios.

Imagine a simple world for a long-term investor with the only portfolio choices currently being Australian shares and Australian bonds.

At the time of writing, Australian 10-year bonds were yielding less than 3 per cent.

The current earnings yield on shares is around 9 per cent – price-to-earnings ratio (PE) around 11.

Dividend yields are almost 5 per cent, with grossed up dividends accounting for franking credits close to 7 per cent.

So the current grossed up dividend yield is more than twice the bond yield. Earnings yields are around three times higher.

Typically shares have traded at a lower dividend yield than bonds.

A recent Strategy Update by Deutsche Bank highlighted that the Australian dividend yield has been higher than bond yields only 3 per cent of the time over the last 40 years. The current differential in favour of shares is the highest in 50 years.

The simple conclusion is that shares are dramatically undervalued and/or bonds dramatically overvalued.

Either way it makes sense for long-term investors to focus on shares not bonds from current levels.

The Deutsche Bank research even indicates that in the year following periods when the yield gap spikes, Australian shares have typically performed well (15 per cent plus).

The ratios are similar in many overseas markets, albeit with both dividend yields and bond rates lower.

Therefore, in regard to the recent industry discussion about the need for more bonds versus equities in investor portfolios, I believe now is definitely not the time to make the switch, unless an investor is already actively drawing down on their assets for retirement or other purposes.

Of course, the real world complicates the simple comparison above.

While the coupons on most government bonds are fixed, the earnings and dividends from individual shares are not.

Further, the Australian share market is heavily skewed to cyclical materials and leveraged financials – banks.

Nevertheless, dividends for the market as a whole, while not immune to falls in tough economic times, do tend to grow over the longer term in line with or slightly below gross domestic product (GDP) growth.

Therefore, unless one is expecting a depression or a much extended recession – a scenario that cannot be totally ruled out – it is realistic to expect those earnings and dividends to be meaningfully higher in five to 10 years time.

A higher earnings/dividend “coupon” in the future is not something you will obtain from a bond purchased today.

We have also ignored inflation, so let’s look at some more specific numbers.

Assume inflation over the next 10 years averages 2.5 per cent, and real GDP is subdued versus history at 2.0 per cent per annum: ie, nominal GDP grows 4.5 per cent per annum.

Assume also that dividends grow at just two thirds the rate of nominal GDP growth: ie, 3 per cent, again a conservative view.

So that means an investor will receive a dividend of 5 per cent plus 3 per cent growth plus franking credits resulting in a pre-tax return of around 10 per cent per annum, assuming PEs don’t change over the period – a reasonable assumption with current PE levels around 11, which is quite low versus history, particularly in low inflation environments.

That is more than three times the return an investor will receive from an Australian 10-year bond held to maturity.

Of course, inflation could be much higher than expected.

However, it is likely shares would withstand higher inflation significantly better than bonds where the real value of the already low coupon yield will be devastated by inflation and there could be large potential capital losses if an investor was forced to sell before maturity.

On the other hand, many corporations would be able to raise earnings/dividends in line with inflation, although this could be partly offset by lower-end PEs in a higher inflation/interest rate environment.

In the real world there are clearly also a lot more investment choices than just Australian shares and bonds, even within the share and fixed interest asset classes.

The fixed interest/defensive component is not restricted to government bonds.

Term deposit rates significantly higher than history relative to the cash rate are currently available, albeit with relatively short maturities.

Corporate debt instruments also offer better returns, and inflation-linked bonds are a further choice.

A portfolio across these and other defensive investments can offer a better prospective return, and lower risk, than government bonds alone.

Likewise Australian shares are just a small part of the global share universe which can help diversify away from the concentration risk in the Australian market.

Listed and unlisted property and infrastructure add another dimension with often attractive yield and total return characteristics.

In addition, there is the broader range of alternative assets and strategies that can further aid diversification by providing returns less correlated to equity and bond markets, and so help smooth the path of returns along the way.

However, adding these additional elements to a portfolio does not change the central premise that shares are currently significantly better value and offer significantly higher prospective returns than bonds over the medium-long term.

Still, even if one is convinced of the investment merits of shares versus bonds as the core of a portfolio going forward, there are still many emotional barriers currently discouraging investment in shares.

Investors look backwards and their recent experience with shares has not been a happy one. Many just want out, disgusted with returns and the share market generally.

For those in retirement without large portfolios, the necessary income/capital draw-downs from a heavily share-oriented portfolio (at the wrong time) have been devastating in some cases.

These investors are clearly those that should never have been so heavily invested in volatile assets in the first place.

For the longer-term investor, especially in the accumulation phase, or even those retirees with large enough portfolios to live off the income, shares should be the cornerstone of the portfolio.
 

For the longer-term investor, especially in the accumulation phase, or even those retirees with large enough portfolios to live off the income, shares should be the cornerstone of the portfolio.

The perceived safety of bonds may satisfy the current need for comfort in the short term, but at current record low yields and with no inflation protection they do little to help achieve longer-term investment objectives.

Of course, those who have been promoting the case for shares over bonds have typically been doing so for some time. Meanwhile bonds have dramatically outperformed.

However, this is not a time to be obsessing about what one should have done in the past, if it had been known that bond rates would reach current low levels.

The logical procedure is to look forward from here and determine what makes sense for long-term investors now, and how they can be convinced to implement it?

Firstly, in my view, the industry needs to get better at articulating the case for shares versus bonds in relatively simple terms, and encouraging investors to ride through current high levels of volatility.

However, I do not underestimate the difficulty of doing this in the current environment; and the additional appropriate response is for portfolio construction to focus on developing portfolios that allow investors to obtain exposure to growth assets in ways that enable them to better handle volatility and shorter-term risks, to ensure they are positioned to benefit from the current longer-term shares/bond valuation anomaly.

It is possible to build equity exposures that are considerably more diversified, less volatile and less vulnerable to large draw-downs than the broader market index, without hampering longer-term returns in all but the most bullish of share environments.

This is why I believe an all-passive approach to growth assets is a flawed approach for many investors in the current environment.

Passive and standard benchmark relative funds can make sense as part of a portfolio, but as the sole solution they are heavily exposed to the very characteristics that share investors are currently rebelling against and unlikely to stick with for the long term.

Those believers in efficient markets are likely to say that the current valuation “anomaly” between equities and bonds reflects the very real risks present in the world.

After all, some of the major macroeconomic risks currently weighing on economies and markets are unprecedented.

However, when one looks at the actual behaviour of a range of participants, it seems the last thing driving many buying/selling decisions – and therefore prices – is rational, objective assessment of the long-term macro risks and their implications for the valuation dynamics discussed above.

Instead we have policy and structural imperatives pushing central banks and financial institutions to buy bonds at virtually any level.

Mutual funds and pension fund investors are being forced to sell equities as their underlying retail investors redeem/switch in fear, irrespective of the long-term value.

Then there are the direct investors grappling with alarmist media headlines, and increasingly giving up and selling out in favour of bonds/term deposits, with their only analysis being how their portfolio has fared in recent times.

Emotive behavioural decisions rather than rational analysis rules the day.

Successful investing requires that long-term value should be bought and overvaluation avoided or down-weighted.

That suggests an increasing skew towards shares and away from bonds/cash in the current environment.

That is certainly not reflected in industry flows or anecdotal evidence.

This is again highlighting the difficulty, but necessity, of being willing to be contrarian to be successful in investment in the long term.

Still, the value and success of the investment industry should at least partly be judged by its ability to encourage investors to build and implement portfolios that appropriately reflect objective judgements of future relative value and prospective returns, rather than just providing emotionally driven investors what they are currently demanding.

If it doesn’t, then the quest to become a profession will fail and investors will be worse off in the long term.

Dominic McCormick is the chief investment officer at Select Asset Management.