I am very fond of all forms of word play. It is a form of wit that is both amusing and intelligent at the same time. It is the very definition of “pun”, the deliberate mixing of two similar sounding words or anagrams.
My pun for today is, “Why do people witter on so much when it’s all about WITA”
Witter: pointless chat or babble pointlessly at unnecessary length.
WITA: What Is The Alternative.
So, let us not witter and get on with WITA.
When confronted with the prospect of ending their working lives, the ongoing erosion of State-provided Social Security funds, due to shifts in demographics, and longer life expectancies, means that individuals will be required to take greater responsibility for funding their own retirement.
Acknowledging there are exceptions, for most there are four main asset classes to which most investors either pre, or post, retirement can easily access.
Bonds (or Debt) are effectively loans the investor makes to governments or companies, which pay an annual rate of interest called a coupon, and provide varying degrees of certainty of the return of one’s capital once the loan is repaid in the future (called the maturity date).
Equities (or Shares) represent partial ownership of a company, and confer the right to share in the future profits (or losses) of a company, by way of capital growth (or loss) and possibly income (through dividends)
Commodities are essentially raw materials which can be purchased by investors as an investment, to either be stored in anticipation of selling at a higher price in the future, or, in rare cases, to be used in a manufacturing process of some sort.
Property in the form of physical immovable property, or some form of company or investment fund, is purchased with the intention of delivering an annual income, and a future capital gain when the asset is hopefully sold at a higher future price It can also be your home.
The two most common assets owned by investors are either bonds or equities, and we look at the relative merits of each, in the context of present market conditions, below:
The most secure assets one can own in bond markets are government bonds (on the basis that governments can always print more money to pay their future debts, so no government should theoretically ever fail to repay its borrowers in their country’s own currency).
Because of the great degree of certainty that one will receive one’s money back when buying government bonds, commensurate returns reflect this. And, at the present time, because interest rates (which dictate the rates at which governments can borrow) have been cut so dramatically since the last financial crisis, the future returns as we stand here today are exceptionally low.
The following chart demonstrates the rates of annual return that major world governments presently pay on their debts for various periods:
For example, lending the Italian government (one of the most indebted nations in the world) Euros for 10 years, would earn the investor an annual return of less than 1%.
It is usually possible to increase ones rate of return by taking more risk. In terms of bond markets, this means lending to companies, rather than governments. The typical rates of return when lending to major, investment grade, companies in Sterling, Euros and US Dollars are at present as follows:
Lending to the typical well rated US company for 30 years would give an annual yield of 2.88%. Admittedly more attractive than the return paid by the US government of 1.76%, but with significantly more risk that the company might not to be able to repay their debt in 30 years’ time. So, facing that level of risk for that level of return, WITA ?
Below we look at the average dividend rate (i.e the average income paid by each company each year) from various world stock markets at present:
Italian shares pay an average dividend of 4% at present. A simple comparison with the average yield paid by the Italian government for 10 years of 0.93%, suggests a large difference in potential return. The difference is, of course, compensation for the extra risk one takes buying a share, rather than lending to a government.
But here is an interesting anomaly. If one were to lend Euros to the Italian insurer, Generali, at present for 10 years, being a typically large, well-rated European company, they would pay an interest rate of around 2%. If one were to buy the shares of the company at present however, the they are expected to pay a projected dividend of around 6% this year. In the most catastrophic circumstances of the company becoming bankrupt during the 10-year period, holders of both the company’s debt, and their shares, would lose all of their money. But the holders of the shares would, before bankruptcy had occurred, would receive an annual income of 6% per annum, versus the holders of the debt, who would have received just 2%.
The above example highlights something we call the Equity Risk Premium. This is the ‘extra’ return one receives as compensation for holding what is perceived to be the riskier shares of a company, rather than being a holder of its debts.
Examples abound. Sanofi, the giant French healthcare company, recently issued a long-dated bond (maturing, or repaying) in 2030, with an annual interest rate of 1.5%. The company’s shares presently pay a yield of 3.3%.
The S&P 500 Index in the US has a current yield of 1.9%. Many financially robust US companies presently have dividend yields of over 3%. By way of contrast, US government bonds pay a rate of 0.6% for ten years, whilst typical US Corporate bonds pay around 1.95% to borrow for 10 years. And dividends of course, under normal circumstances, continue to grow.
Returning to the ERP, Equity Risk Premium.
“So, it’s all over. The end of equities”, published 5th April 2020
The above is a very good practical illustration of ERP, the difference between returns on an equity or equities and the risk-free rate of return, typically a government bond (because governments normally pay).
The most important of outcomes of any investment are realized gains, not price movements. Part of that is real income. Without income, your money is not working for you.
Now, you might be reading this thinking "they're both crazy." After all, the U.S. economy contracted at a record rate last quarter, with the GDP crashing at a 32.9% annual rate.
Second-quarter US GDP contracted at an annualised 32.9%, but against economists’ forecasts of 34.5%. The second-quarter contraction was the biggest drop in U.S. GDP growth ever recorded. Unemployment in the US increased to 17 million in July. Perhaps the jobs recovery is losing momentum? Although that unemployment rate has ticked down to 10.2% from over 11.5%.
FactSet (TEAM subscribe to this data analytics research company), estimates the forward 12-month price-to-earnings ratio for the S&P 500 to be 22.2x. For context, that 12-month forward valuation is 30% above the 5-year average of 17.0x, and 45% above the 10-year average of 15.3x.
Company analysts were very pessimistic for the June end quarter company earnings in the US. The average consensus estimate forecast a 43% earnings decline! Thankfully, many companies have performed better, and there have been many positive earnings surprises. According to FactSet, 84% of the S&P 500 companies that have reported posted an earnings surprise.
Pleasingly, the second-quarter earnings announcements from the majority of TEAM’s global equity investments have been rewarding because of their better-than-expected earnings and positive guidance. As a result, we remain confident in the composition of our portfolio and expect to the companies we own to emerge from 2020 in a stronger competitive position within their respective industries.
But we are now in what has historically been a bumpy month for equity markets, August. August has traditionally been characterized by bouts of high volatility, light trading volumes and headline-grabbing activity by short sellers. Presidential election years tend to be the exception, but this year is different. So, we wouldn’t be surprised if August delivers a lacklustre return. Seasonal patterns would suggest this is normal.
This August falls in a presidential election year. Typically, the stock market moves higher during presidential election years. Candidates from both parties look to appeal to voters. The respective Republican and Democrat Party campaigns are yet to begin in earnest, so it will be interesting to see if the candidates take a more positive stance and boost consumer confidence in the coming weeks.
The quicker life gets back to normal, the more optimistic investors will be. By mid-September, quarter-end window dressing, as well as the ETF realignment, will commence and should boost markets as institutional investors look to make their portfolios more attractive for quarterly reviews.
We remain positive on fundamentally strong stocks, which we define as companies that can sustain strong sales and earnings, regardless of any negative news flow surrounding broader market indexes. Persistent, sustainable free cash flow generation has always interested us, a fact that has been considerably rewarded by the market in recent months and will continue to be, as living with the coronavirus becomes a longer-term consideration.
The reality is that the Dow continues to yield more than five times more than the 10-year Treasury, which has slipped below the 0.6% level. So, yield-hungry investors are looking to dividend stocks.
Lastly, In March, corporate executives/directors in the US invested into the shares of their own companies at rates not seen for many years.
However, the situation has changed quickly. This has slowed to minimal.
Overall, it would be foolish to underestimate the giant stimulus boost being injected into the economies of the world. Particularly, America, which is a consumer-based economy and consumers are roughly 70% of the economy. The more they spend the stronger the economy. Not every company or stock will be a winner. At TEAM, we like to keep our investment philosophy simple and look for companies that can be market leaders.
With US national debt being forecast at 107% of GDP in 2025 (around $26 trillion), interest rates are likely to remain at effectively zero for a very long time. This is positive for high quality company shares or equity. There are undoubtedly bubble-like conditions brewing in pockets of the market but I repeat, stocks with positive revenues and earnings remain the place to invest.
If US rates were to rise it would bankrupt the country. Also, inflation is nowhere to be seen at present. We have deflation. So, again no cause for rate policy change.
Lastly, there are numerous (over 160) credible vaccines in the pipeline alongside significantly faster testing devices from multiple companies. Russia has announced the clearance of a vaccine for widespread use in their country.
A vaccine would be a massive boost for particularly the US economy. It could lead to unprecedented growth.
Further for the short term, August through September, I also think that expectations of a vaccine solution are now so over hyped that the confirmation of a successful vaccine could prove the be a “sell the fact” for the equities markets.
Aligned with a historic recovery we are on the verge of the next advancement in mobile technology. The acceleration of the digital and data revolution. It is no secret that some of the best stock market outperformers have come from the tech sector. And the trend in our looks as strong as ever. The big tech companies reported stellar results.
Amazon a 605% earnings surprise. Facebook, 29.5%, Google (Alphabet), 23.4% and Apple, 26.5%.
The “stay at home” working world has been a transformational shift in our economies that will continue to unfold for many years. It’s not just in big tech companies. Covid and the upheavals it’s brought about for businesses and consumers, will change large portions of the global economy. Some are obvious. Others will be in less obvious ways, but no less spectacular.
There is a lot more to this transformation than the past 3 months of share price gains we have seen. History is being written.
Notwithstanding a potential setback in August/September, we think there is a lot to be excited about. The stock market continues to be the best of the alternatives for investors. Any corrections should be viewed as an opportunity.