Investors should prepare for disappointing real returns


Serious Money:Equity prices have jumped to within touching distance of all-time highs, and the upturn in investors’ fortunes has pushed valuation ratios to levels that have preceded protracted periods of poor stock market performance in the past.

There is a widespread belief that stock market returns mean-revert over the long-term. Based on this belief it could well be possible to use the information contained in high valuation ratios to time the market, and capture the favourable combination of lower risk and higher returns. An interesting paper authored by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School, and recently published in the Credit Suisse Global Investment Returns Yearbook, casts doubt on this view.

The academics assess the predictive ability of a cyclically adjusted price-dividend ratio (the ratio of the current real index level to the average of the preceding 10 years’ real dividends) across a variety of world stock markets. They conclude that, “we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past”.

The choice of valuation metric appears reasonable, since dividend payments, unlike earnings, cannot be manipulated, and often reflect a company’s own view of its long-term earnings power. But there is no theoretical reason as to why a cyclically adjusted dividend-price ratio should mean-revert, since the higher multiple might simply reflect substantive changes in the percentage of earnings that companies decide to pay to shareholders. It is important to appreciate that stock market value is made up of both current dividends and expectations for future growth.

The pace at which dividends grow in the future depends on the percentage of earnings that a company distributes to its owners, and the rate at which retained earnings are reinvested in the business.

In other words, a low dividend yield might simply reflect a lower payout ratio, and higher expectations of future growth.

Historical data for the US demonstrates that the corporate sector’s payout ratio has been in secular decline for decades.

The 10-year average payout ratio dropped from a peak of almost 90 per cent in 1940, when expectations for future growth were virtually non-existent, to below 40 per cent in 2007. By then expectations for uninterrupted growth for the indefinite future held sway.

Long-term differences in payout policy means that it is impossible to identify a mean around which the cyclically-adjusted dividend-price ratio might oscillate.

Financial theory suggests that we should be able to observe a negative relationship between corporations’ payout ratios and subsequent growth rates in earnings and dividends.

In other words, higher growth rates would be expected to follow lower payout ratios and vice versa, but if this expectation is frustrated, then the dividend-price ratio might retain some predictive ability, as disappointing growth outcomes are reflected in lower share values.

The historical evidence in both the UK and the US reveals that low payout ratios have typically been followed by surprisingly low real growth rates over subsequent 10-year periods, and not the high rates of expansion that might have been expected at the outset. This surprising outcome suggests that the corporate sector is either over-investing, or that competitive markets quickly erode excess returns, or that low payout ratios reflect management’s intention to signal lower future growth to shareholders.

Sounder valuation metric

In light of the above, the dividend-price ratio does retain some predictive ability regarding future real returns, but it is still not possible to say what level is indicative of fair value. As a result, it would be wise to replace the cyclically adjusted dividend-price multiple with a valuation metric that rests on sounder theoretical footing.

In this regard, the Q-ratio, developed by the late Nobel laureate James Tobin in 1969, is a natural choice. This metric measures the market value of equity relative to its replacement cost, and a fundamental relationship should exist between the market value and replacement cost; corporations should be valued at their cost of creation in the long-run, and as a result, the multiple should hover around unity given rational expectations.

The “law of one price” or “build-or-buy” arbitrage should ensure that the relationship holds over long horizons. A ratio above unity implies that it is cheaper to invest in new capital rather than buy existing capital, while a figure below unity suggests the opposite.

The historical data confirms that the Q-ratio does indeed demonstrate mean-reverting properties, and importantly, the analysis reveals that the adjustment takes place through a change in real share prices rather than changes in the capital stock. In other words, Tobin’s Q can be used to predict long-term real returns.

Unfortunately for equity investors, the current value of Tobin’s Q is almost 40 per cent above its long-term mean – a level that has rarely been exceeded in the past. The ratio’s elevated level, in tandem with its mean-reverting properties, does not mean a catastrophic decline is imminent, but it does suggest that disappointing real returns are virtually assured over long horizons.

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