Equity Investing – Just 2 things to remember

In our previous two posts, we had covered in detail, the two key factors to evaluate when investing in equities. In case you haven’t read them, do take some time out to read them here – Link 1  Link 2

Now for those who don’t have the time and would like a “no-nonsense” summary of those posts, hang on, this post is just for you folks !!

Quick Summary

1. Equity market returns are driven by
   • Earnings growth
   • Increase or decrease in Valuations
   • Dividends (In India, this component is not too significant and adds to around 1 to 1.5% additional returns for the Sensex annually)
2. Earnings growth and Valuations are cyclical
3. Earnings growth is the key determinant of long term equity returns
4. So always evaluate which part of the cycle are we in terms of earnings growth
5. Valuations = weighted average market opinion on the value of companies
6. Valuations are a key contributor to the short term volatility seen in equity markets
7. Evaluate if valuations are expensive, cheap or neutral (degree of difference with the long term average – ~15-16 times 1Y forward PE for Sensex)
8. Do this evaluation once in 3 months
9. Based on your evaluation, decide on whether you have to adjust your overall allocation to equities within your portfolio
   

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Musing no 1: Stock prices are slaves of earnings growth in the long run !

Now to understand the role of earnings growth and stock prices better, lets take the help of investor Ralph Wanger who has come up with an interesting analogy between the stock market and a man walking a dog.

“There’s an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the dog watchers, big and small, seem to have their eye on the dog, and not the owner.”

The dog in our case is the stock price and the owners walking speed and direction is the earnings growth !!

Musing no 2: Starting Valuations matter !

While earnings growth is the dominant driver of equity returns over a long investment horizon (let’s say >5 years), the starting valuations also play an important role as an increase in valuations can provide additional returns over and above earnings growth and vice versa. Generally valuations tend to revert to their long term averages . Think of valuations as tied to a pole called “long term average” with a rubber band. The farther away the current valuations of the market moves away from long term averages the higher is the force from the rubber band to bring them closer to the long term averages.The mean reversion effects of valuation have a significant impact on the overall returns in the near term and gets gradually evened out in the long term.

Starting Valuations = Low
Mean reversion in valuations will provide additional returns over and above earnings growth

Starting Valuations = High
Above normal earnings growth & Long investment time frame needed to nullify the impact of mean reversion in valuations

In order to appreciate the impact of starting valuations, I have calculated the annualized return impact over different time horizons due to valuations returning  to their average ( 16 times 1Y Fwd PE) assuming no contribution from earnings growth (i.e assuming it to be 0%)

As seen above, higher starting valuations have a significant impact over returns in the short term if they were to mean revert (which is most often the case). For eg if you had invested at 24 times PE and it mean reverts to 16 times in 5 years it would have provided ~negative 8% annualised impact on the overall returns (read as earnings growth). Long investment time frames & above normal growth are required to subdue the impact of overvaluation.

Lower starting valuations, provide the potential for significant upside in case of mean reversion. For eg if you had invested at 12 times PE and it mean reverts to 16 times in 5 years it would have provided ~positive 6% annualised impact on the overall returns (read as earnings growth).

Thus summing it up..

1. Stock prices are slaves of earnings growth in the long run !
2. Starting Valuations matter !

PS:

For those who are still with me, check out how the actual 10 Year sensex returns have been impacted by earnings growth and valuations

Source: MOSL