Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 413

Where will investment returns come from in 2021?

As Australian equities have rebounded from the lows of late March 2020, many investors have doubted the rally's staying power. Pessimists argue that, based on most valuation metrics, stocks are pricey, which implies weak returns ahead.

But we believe that this overrates the predictive power of valuations, particularly in the short term. Instead, investors need to understand that long-run equity returns are driven by multiple components, of which valuation is often the least important.

Indeed, it is likely that in coming years investors won’t be able to rely on rising equity valuations for their returns. To achieve high returns and realise their investment goals in this environment, they are going to have to become even more focused on identifying the companies that can produce strong earnings growth and cash flow.

There are only three components of returns

Figure 1: Components of ASX Total Returns (% per annum)

Figure 1 decomposes Australian equity market returns into their key components. As you can see, there are only three sources of returns:

  • Income (grey bar) – dividends
  • Earnings (orange bar) – how fast have companies grown their earnings?
  • Valuations (blue bar) – how has price/earnings multiple changed? Does the market now value companies more or less for a given level of earnings?

The first two components of return are generally referred to as the ‘fundamental’ components, whilst valuations are often referred to as the ‘speculative’ component of return. The latter has earned this moniker because it is driven by unpredictable investor emotions, such as fear and greed, in the short term.

(The sum of these components approximates the return on the stockmarket, shown with a black diamond.)

An erratic contributor

The sources of return never change but their order of importance does. That is, during any of the five-year periods presented, one of these variables will exert a disproportionate influence on total equity returns. Conversely, there will be periods where a component makes little contribution.

There is no doubt that when valuations expand it can have a dramatic positive impact on total return. But valuation’s contribution is highly erratic: sometimes positive, sometimes negative. When the P/E ratio expands, the stock market generally produces double-digit returns. And when the ratio contracts, returns fall into the single digits.

In the second half of the 1980s and the second half of the 1990s, for example, the P/E ratio was a strong driver of the era's spectacular market returns. But P/E detracted from market performance through the years 2000 to 2015 when valuations subsided from the start of the high-tech bubble.

The exhaustion of PE expansion

When P/E multiples are expanding, interest rates are typically falling, and vice versa. For the two decades between 1980 and 2000, the downward trend in interest rates boosted P/Es, which resulted in huge growth in total equity returns.

More recently, we have seen this play out as central banks worldwide have drastically cut interest rates to support economies facing pandemic pressures.

But with interest rates now having already been reduced to the floor, the era of P/E expansion has been exhausted: it is unlikely that rates can fall much lower and push further P/E expansion. Instead, rising rates over the coming years – as economic growth recovers -- are likely to force a modest decline in equity valuation multiples, similar to what markets digested through the years 2000 to 2010.

This negative outlook for P/E ratios emphasises the other two sources of equity return: earnings and dividends. As you saw in Figure 1, earnings and dividends, unlike the highly volatile P/E ratio, have had a consistently positive effect on total return over the last 40 years. In fact, for much of the last 20 years, earnings and dividends have continued to boost total return, while P/Es have hindered market performance.

The emerging primacy of earnings and dividends

But while earnings and dividends become more important as sources of returns, the period of double-digit earnings gains for the broader equity market will soon be behind us as economies normalise post the COVID-19 pandemic. Going forward, earnings growth will likely occur at a more modest single-digit rate.

Fortunately, our investment process has always focussed on finding the companies that can materially grow earnings. In this environment, our expertise in identifying the profitable growing businesses of the future comes to the fore.

Meanwhile, because they are often a preferred method of free cash flow deployment, dividends are set to emerge as a more important component of total equity returns. Although we are biased to companies that can grow earnings faster than the market, we will continue to learn everything we can about a company's free cash flow and what it signals for the businesses capital management policies.

A solid year of returns from equities

Valuations are not good predictors of short-term market returns. It is futile for investors to use valuations to time the market day-to-day or month-to-month.

Valuations could fall but that does not mean returns have to be negative if the other two drivers contribute enough.

For long-term investors, the best course is to continue investing according to your plan, regardless of what the market does. You may, at times, buy when valuations are high; on other occasions, you will buy when valuations are low. It should all come out in the wash over the long term.

Our base case is we expect a year of solid returns from equities in 2021, but with the usuall high degree of uncertainty. The global economic recovery, which is currently playing out, suggests that earnings growth should positively contribute to markets in 2021.

The big differences could arise from valuations. Dividends should also be well supported this year, particularly in commodity and consumer-related stocks.

We think investors can no longer rely on a rising tide of higher valuations to lift all stocks. Alpha or outperformance, where it can be found, will be a larger portion of total investor returns. We focus on finding undervalued small and mid-cap companies that through a superior product or service can become the future leaders of tomorrow. These types of businesses will continue to be rewarded with expanding valuations as the market recognises their superior growth trajectories.

 

Andrew Mitchell is Director and Senior Portfolio Manager at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

Read more articles and papers from Ophir here.

 

RELATED ARTICLES

Is your fund manager skilful or just lucky?

Four tips to catch the next 10-bagger in early-stage growth

The growth outperformance myth

banner

Most viewed in recent weeks

2024/25 super thresholds – key changes and implications

The ATO has released all the superannuation rates and thresholds that will apply from 1 July 2024. Here's what’s changing and what’s not, and some key considerations and opportunities in the lead up to 30 June and beyond.

Five months on from cancer diagnosis

Life has radically shifted with my brain cancer, and I don’t know if it will ever be the same again. After decades of writing and a dozen years with Firstlinks, I still want to contribute, but exactly how and when I do that is unclear.

Is Australia ready for its population growth over the next decade?

Australia will have 3.7 million more people in a decade's time, though the growth won't be evenly distributed. Over 85s will see the fastest growth, while the number of younger people will barely rise. 

Welcome to Firstlinks Edition 552 with weekend update

Being rich is having a high-paying job and accumulating fancy houses and cars, while being wealthy is owning assets that provide passive income, as well as freedom and flexibility. Knowing the difference can reframe your life.

  • 21 March 2024

Why LICs may be close to bottoming

Investor disgust, consolidation, de-listings, price discounts, activist investors entering - it’s what typically happens at business cycle troughs, and it’s happening to LICs now. That may present a potential opportunity.

The public servants demanding $3m super tax exemption

The $3 million super tax will capture retired, and soon to retire, public servants and politicians who are members of defined benefit superannuation schemes. Lobbying efforts for exemptions to the tax are intensifying.

Latest Updates

Retirement

Uncomfortable truths: The real cost of living in retirement

How useful are the retirement savings and spending targets put out by various groups such as ASFA? Not very, and it's reducing the ability of ordinary retirees to fully understand their retirement income options.

Shares

On the virtue of owning wonderful businesses like CBA

The US market has pummelled Australia's over the past 16 years and for good reason: it has some incredible businesses. Australia does too, but if you want to enjoy US-type returns, you need to know where to look.

Investment strategies

Why bank hybrids are being priced at a premium

As long as the banks have no desire to pay up for term deposit funding - which looks likely for a while yet - investors will continue to pay a premium for the higher yielding, but riskier hybrid instrument.

Investment strategies

The Magnificent Seven's dominance poses ever-growing risks

The rise of the Magnificent Seven and their large weighting in US indices has led to debate about concentration risk in markets. Whatever your view, the crowding into these stocks poses several challenges for global investors.

Strategy

Wealth is more than a number

Money can bolster our joy in real ways. However, if we relentlessly chase wealth at the expense of other facets of well-being, history and science both teach us that it will lead to a hollowing out of life.

The copper bull market may have years to run

The copper market is barrelling towards a significant deficit and price surge over the next few decades that investors should not discount when looking at the potential for artificial intelligence and renewable energy.

Property

Global REITs are on sale

Global REITs have been out of favour for some time. While office remains a concern, the rest of the sector is in good shape and offers compelling value, with many REITs trading below underlying asset replacement costs.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.