Go for value in the market and let compounding work its magic

Seek stocks or funds with higher initial dividend yields and it’s easier to achieve long-term target returns

In this concluding article in the series outlining themes and concepts from my recently published book 3 Steps to Investment Success, I clarify the key differences between value investing and growth investing, and how insisting on value today is a good deal easier than relying on growth tomorrow.

The developed stock markets have delivered returns of 5-6 per cent in excess of inflation or 9-10 per cent annually (before costs) over the past century.

Today, annual inflation is running at circa 2-2.5 per cent in the developed world. Hence, if these markets are valued as they have been on average this past century then they should be able to deliver returns of 7-8 per cent annually from here (2.0-2.5 per cent plus 5-6 per cent).

Likely annual returns

While the US stock market is valued above long-term norms, the euro zone markets are exceptionally cheap relative to history. Taken together, I’d say 7-8 per cent is a reasonable guide to the likely annual returns from developed markets from here on a five to 10-year view.

There are two ways of getting the likely 7-8 per cent annual return on offer. The first, and more precarious way, given the current lack of growth in the global economy, is to start with a dividend yield of 2.5 per cent, which the US SP 500 Index offers, and assume growth of 5 per cent annually in that dividend yield. This would result in an annual return of circa 7-8 per cent, over time. But most of the returns will have to come from growth so that the certainty factor is low.

The second way is to start with a higher initial dividend yield. If we take a diversified exchange-traded fund (ETF) that focuses on higher dividend paying stocks internationally (referred to as a fundamental ETF) – like the WisdomTree Global Equity Income Fund (ticker code: DEW) which currently offers a dividend yield of 4.6 per cent – then it is a good deal easier to achieve the target return of 7-8 per cent.

To achieve the same 7-8 per cent annual return, we just need annual growth in the dividend income stream of 3 per cent. For the sake of simplicity, let’s assume we are dealing with a pension account so that tax issues can be ignored.