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| Akash Prakash: Global equity returns | | There is very limited margin of error for Indian equities |
| Akash Prakash / New Delhi Sep 10, 2010, 00:29 IST |
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There seems to be great fear and concern towards equities in the developed world at the moment. In a world where a company like Johnson & Johnson (J&J) can issue 10-year corporate bonds at a record low yield of 2.95 per cent, even lower than its dividend yield, and the bonds get lapped up, but no-one wants to touch the equity, something odd is happening. What is the chance of the J&J bond-owner outperforming the equity-holder over the coming decade? The only rationale can be investors expecting a deflationary type of an economic environment, wherein equities drop significantly from here, and any yield is valuable. Despite the current level of bond yields, even now we see continued outflows from equities towards bond funds.
However, realistically what type of returns can global equity investors expect from here over the coming decade? Do these expected returns justify a seemingly irrational desperation for capital preservation and yield at any price as shown by the J&J bond?
To forecast long-term equity returns, one has to make certain forward projections of earnings per share (EPS) growth, dividend yields and then make an estimate of an appropriate multiple one can apply to these earnings.
The starting point for forecasting long-term earnings growth is normally nominal GDP, with the assumption being that EPS broadly tracks nominal GDP over the long haul. At first glance, this looks reasonable as in the US, EPS growth since 1980 has been about 5.5 per cent per annum, broadly in line with nominal GDP growth of about 5.9 per cent (source: BCA). For global markets as a whole, over the last 15 years, EPS growth has actually been slightly faster than that of nominal GDP. However, as the folks at BCA point out in a recent study, while EPS has kept up with nominal GDP, sales per share growth has actually lagged quite significantly. The implication of this divergence is, of course, that rising profit margins have filled in the gap. Profit margins have risen considerably across regions, and there are obvious limits to how much more they can expand. BCA points out that if you recast the numbers by holding margins flat, then EPS growth across the world has significantly lagged that of nominal GDP. The EPS growth for US companies (since 1980) would have been only 4.5 per cent (not 5.5 per cent). The adjusted numbers are even worse for non-US and emerging market (EM) companies. For developed market (DM) companies as a whole, EPS growth (since 1995) was 2.6 per cent per annum compared to 4.1 per cent for nominal GDP, and for the EM, world EPS growth was an annualised 4.3 per cent compared to a nominal GDP rate of 9.3 per cent.
With the benefit of hindsight, this gap between EPS and nominal GDP is not surprising. Even though the profit share of the overall corporate sector to GDP has been quite stable, as new private companies get created, they take a larger share of the profit pool, reducing the share attributable to the older, more established listed entities. This phenomenon is especially pronounced in the faster-growing EM countries which, combined with greater equity dilution to fund growth, explains the higher EPS gap in these economies.
Now in a world where we expect economic growth to be subdued, and profit margins seem unlikely to expand as robustly as they have over the past two decades, the outlook for EPS growth is quite challenged.
The second part of the equation relates to PE multiples, and what is a fair number to use, looking out 5-10 years ahead. Over time, PE multiples have clearly reverted to the mean and hence some type of long-term average should work as a reasonable estimate. Currently, US equities trade at about 15 times earnings, below the long-term average of 17, and the average PE multiple of 23 since 1995 (source: BCA). Global equities trade at about 12 times earnings, well below their average of 17. On this basis, equity returns over the coming decade should be boosted by some valuation expansion, as multiples move towards long-term averages. The only reason this may not occur is if, as expected, real interest rates rise significantly over the coming decade, given the currently artificially low levels, which would act as a natural dampener to multiple expansion. Another factor weighing on multiples would be the economic uncertainty we currently face — deflation, another Japan-like lost decade, a European sovereign crisis? Global economic uncertainty has rarely been higher.
The folks at BCA have been conservative in their study and have assumed no multiple expansion in their five-year projections, thus their market return assumptions are based purely on EPS growth and dividend yields.
On the above basis, they come up with an expected annualised real return of 4 per cent per annum for the MSCI global equity index, with 2.9 per cent of this coming from dividends and the balance from EPS growth-linked capital appreciation. While lower than the average return of 6.1 per cent since 1980, it will still outpace anything available from fixed income assets. Once again, one wonders what the buyers of the J&J bond were thinking.
An additional insight from the study is the realisation that the huge outperformance the EM asset class has enjoyed over the last decade is likely to come to an end. While the BCA study expects EM equities to outperform DM equities over the coming five years (4.8 per cent versus 3.7 per cent), this performance differential is nothing compared to what actually transpired in the last decade (EM equities delivered a real annualised performance of 6.6 per cent versus 2.1 per cent for DM equities). The last decade’s outperformance of EM equities was driven by rapid margin expansion as well as the fact that EM equities began the decade far cheaper than their DM counterparts. At some stage, EM profit margins will plateau (they are already 3.2 percentage points above DM margins), and today, on virtually any valuation measure, EM stocks are more richly valued than their DM counterparts. The EM valuation premium is also visible across sectors.
India stands out in the BCA study as being the most expensive of the BRIC markets, and, in fact, screens as being among the least preferred with lower-than-average expected returns over the coming five years. The low expected return for India is driven by multiple compression as the methodology of the study brings our multiples down in line with the EM average. If India can continue delivering strong economic and earnings growth, backed by determined political leadership, then this multiple compression need not take place. If we can hold our current valuation multiples, then India’s expected return profile moves from being in the lowest quartile to the highest quartile.
The bottom line is that for Indian equities to deliver strong returns from here, we have to hold on to current valuation multiples. In the absence of improvements in governance, political will and economic decision-making, this will not happen.
A bet on India today is implicitly a bet on improved governance, more decisive economic reforms and the ability to take on vested interests. Can we deliver? There is no room for error.
The author is the fund manager and chief executive officer of Amansa Capital
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