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Sunday, August 1, 2010
Avoiding anxiety

Price volatility causes investors great anxiety, but they should rather focus on the income that investments generate over time. Admittedly, longer term means more than five years when it comes to equity investments.

The income element of the total return equation is far steadier than daily, weekly, monthly price movements. There are essentially three components to an investor’s total return when investing into a company:
• Initial dividend yield;
• The growth of those dividends over time; and,
• The rating change (i.e. the change in the valuation of the share from the time acquired to the time valued or sold – either negative or positive).

When measured over various times, 10, 15, 25 and 40 years, for example, dividend growth as the predominant driver of equity returns has been remarkably steady. If an investor capitalises on buying when starting yields are juicy, i.e. attractive starting prices, then this initial yield serves as a very long run booster to the total return.
On the other hand, rating change (changes in valuations of company earnings/dividends), depicted by price volatilities has not contributed substantially to the total return. We know that over discrete periods of time, markets can move from undervalued to overvalued and this can add immensely to an investor’s total return. But over longer periods of time, this rating change is mean reverting and so does not feature as a permanent component of the total return to an investor.
Annually JP Morgan updates a total return report across all local asset classes. The components of total return for local equities can be depicted as follows: firstly, price return, which is the aggregate of dividend growth and rating change and then adding this to the starting dividend yield to give the total return.
This chart indicates that in nominal terms, dividend growth has tended to average around 12% per annum. Over the 40 year period, rating change has added 2,6% per annum to total return.

Adding the starting dividend yield to the price return gives an investor his total return. Over the 40 years to the end of 2009 the JSE has provided investors with a total return of around 20%. Over the past 50 years, the total return has been very similar at 19,4%.
Given the fact that earnings growth was strong over the past five years, together with fact that inflation should remain at the lower end of its historical number, the nominal expected return from a basket of listed equities should be closer to the 12% - 15% range than 20% in the future.
Assuming a long run inflation of 5%-6%, then long-term investors should still expect a 7% - 8% real rate of return, which is better than bonds or money market, albeit at higher volatility.

Copyright © Insurance Times and Investments® Vol:23.8 1st August, 2010
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