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

Tue, Nov 20, 2012, 00:00

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.

Funds for private investors

Assembling a portfolio of globally diversified funds with high initial dividend yields of circa 5 per cent is easier with fundamental ETFs, which are designed as passively managed index trackers but with a value bias, in this case a yield bias.

In my view, fundamental ETFs are an excellent fund-type for private investors. To achieve the long-term returns of 7-8 per cent needs annual growth of just 2.5-3 per cent in the dividend income stream.

As the old adage goes, a bird in the hand is indeed worth two in the bush. Why wait for growth tomorrow when you take most of the returns through income today?

If you can achieve a 7-8 per cent annual return from risk assets, while controlling the risk by investing through diversified, low-cost funds like exchange-traded funds then, despite the inevitable disruptions from recessions and the bear markets which they bring with them, you are well on your way to obtaining the above average returns that stock markets have generally delivered over time when compared to bank deposits.

These returns will not be straight line, of course. Investors often mistakenly believe that you need to find growth companies in order to succeed when investing through the stock markets. As most of us are not equipped to tell which are the real growth companies and which are the likely pretenders, this approach to stock market investing is a higher risk one.

Measuring the value you are being offered today and assuming modest growth is the surer, if less exciting, route to take. The benefit is that everyone in society can achieve the returns on offer this way.

Steps to investment success

I suggest, in my book, there are just three steps to investment success. The first is having a plan, and concentrating on high dividend yielding funds that are well diversified is a solid plan. The second is to avoid letting volatility interrupt your long-term investment plans (dealt with last week). The third, and final, step is to have the patience to let compounding work its magic over time.

Achieving the long-term returns available from markets is easier than many investors think. Generating above average returns is more difficult than most appreciate. There are no guarantees, of course, but with a 5 per cent initial dividend yield in the bag the target of a 7-8 per cent annual return is not unrealistic either. As always, though, the timing of the returns is uncertain.

In terms of your long-term financial planning, be it for your pension fund or otherwise, the difference between an 8 per cent annual return from risk assets and, say, a 3 per cent return from bank deposits is enormous over time. The time you give to your savings programme is also important in compounding.

Let me give you an example. As Table A highlights, the person who could save €500 a month, or €6,000 a year, from the age of 25 to 34 – for a total commitment of €60,000 over a 10-year period, and who obtains an annual return of 8 per cent per annum never has to add another cent to his investment programme after the age of 34, and still ends up with a lump-sum of over €1 million at the retirement age of 65.

The same saving programme in cash deposits earning 3 per cent (which is optimistic currently) would result in a lump-sum of €177,123 at the retirement age of 65.

Lessons from the past

History shows that investing in risk assets, when they are sensibly priced, as, with the exception of the US market, they generally are today, results in significantly higher returns than can be achieved in bank deposits. It is the reason why we choose to save and invest through the stock markets or indeed in physical property.

No wonder Warren Buffett called his autobiography Snowball – build a small snowball and roll it downhill: after sufficient time watch it grow in size using nothing more than its own weight.

In Ireland, the Special Savings Incentive Accounts (SSIA) from 2001 to 2006 was the right one, but it ended too early. Savers did not have the time to benefit from compounding. Learning how to invest should enable you to obtain the returns on offer in risk assets, while controlling the risks.

Most of us in Ireland may have made a botch of investing in the 2000s, but it is never too late to learn. At the very least, we owe it to the up and coming generation to make sure they do not make the mistakes of this generation.

RORY GILLENis the founder of Gillenmarkets.comand author of the recently published 3 Steps to Investment Success. The book is priced at €19.95 and can be bought at gillenmarkets.comand in most book stores

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