February/March 2013 Investment Analysis: The Bounce Back

In association with Sarasin & Partners

Investors have enjoyed a strong bounce in share prices over the last few months and understandably are asking whether this is just another bear market rally in the ‘Lost Decade’, or whether we are at last emerging from one of history’s most disappointing periods for equities?

The Lost Decade (or perhaps we should call it the ‘Lost Decade, or so’ as it has been
13 years) is used to describe the period since the start of the Millennium, a period during which the UK stock market has made no progress in capital terms.

The start of the Millennium coincided with the peak in the UK stock market. Returns had been exceptional in the 1980s and second half of the 1990s and the average annual total return for the period 1995 – 1999 was over 20 per cent per annum, which with hindsight was unsustainable. It was a period when the internet and technology were starting to have a material impact on our lives and investors extrapolated this into inexorable profits growth.

As this growth did not materialise quickly the dotcom bubble burst and share prices fell.
The volatility that followed was considerable, the FTSE 100 halved over the next 3 years before regaining most of the loss over the following 4 years as we approached the Financial Crisis – the rest, as they say, is history. It halved again over the next 18 months and even today the stock market is below the 1999 peak.

But to stop there would only tell half the story because whilst the stock market has stagnated, companies have continued to grow their profits and dividends. The table at the bottom of this page puts profit growth for UK companies into the context of the last century. UK corporate profits have grown by an average of 3.6 per cent per annum over the 13 years since 2000 (including an estimate for 2012).

This is lower than the long term average of 7.2 per cent per annum, but it is nevertheless growth. If one considers the average growth in real terms (adjusting for inflation) the situation looks somewhat better. Inflation has averaged 3 per cent over the same 13 year period and real growth in profits has been +0.6 per cent per annum.

Comparing growth in real terms is important as it puts into perspective periods such as the 1970s when inflation averaged 13.1 per cent, thus reducing the strong profits growth of 15.9 per cent to just 2.5 per cent (which is the long term average). If we use corporate dividends instead of profits, then the picture improves because dividends have grown by 4.7 per cent per annum over the same period, which is 1.1 per cent higher than profits.

Dotcom bubble
In the period leading up to the Lost Decade, 1995 – 1999, the stock market rose much faster than profits, but thereafter the situation reversed with profits rising the fastest. While equities have stagnated for 13 years, their performance apparently bears no resemblance to the underlying profitability of companies.

Despite this, over the last few months investors have enjoyed a strong bounce in stock markets and investors are asking “is the recent equity bounce sustainable or is the ‘equity model’ broken?”

At Sarasin & Partners, we believe that the equity model is far from broken. The reason for the poor equity returns over the last 13 years has been arguably more to do with its extraordinarily high initial valuation than a fundamental breakdown in the underlying companies or economies in which we are investing.

The key drivers for share prices are: dividends, the growth in dividends and the revaluation of dividends (or put another way the price earnings multiple expansion or contraction). If we assume that there will be no re-rating, because we are starting from an average valuation level, then the key to future equity returns is the growth in dividends.

Cyclical crisis
History shows that dividend growth is reliant on economic growth so we need economic growth for equities to make progress. Is economic growth likely to revert to ‘normal’ over the next few years?

We think there is every chance that it will improve, albeit not getting back to what is considered completely normal, for several reasons. While the recent cycle has been extreme because of the severity of the Financial Crisis, it is a cycle nevertheless and although cycles differ in terms of shape and duration, capitalism has a strong ‘self-righting’ mechanism that causes the elastic to eventually snap back.

It is not only capitalism that creates the cycle, the world’s central banks via Financial Repression measures have created an environment that is highly stimulatory to encourage consumers and businesses to consume and invest and the Central Banks’ desire to embed higher levels of nominal economic growth should not be underestimated as it helps to eradicate high levels of debt – let’s hope that higher nominal economic growth results in higher real economic growth as well.

In addition there are powerful and inevitable demographic changes that lead us to believe that the global economy will continue to grow as it has done before, albeit with considerable help from the emerging countries. The global population is estimated to increase from 7 billion to 9 billion over the next 40 years. Not only will there be more people consuming but there will be investment in infrastructure, housing and cities.

Technology will continue to play its part in increasing productivity and helping raise agricultural yields which will be vital on our crowded planet. As well as more consumers, there will be a larger emerging market middle class and the wealth that this newly economically empowered society brings with it to spend on high value goods and services. Energy efficiency will need to be carefully managed in this environment but progress appears to be being made here as well.

Recovery usually takes longer after a recession that has resulted from a financial crisis and this cycle is unlikely to be any different because of the deleveraging and austerity programmes that are occurring in many of the advanced western countries.

Economic growth tends to be lower for highly indebted economies (usually described as economies with debt/GDP ratios in excess of 100%), which is where most of the developed economies are likely to be. This is because some of the resources normally used for investment are used for interest and capital repayments instead, so it would be reasonable to make an allowance for this in medium term assumptions.

It would be wrong to isolate the analysis to the UK economy because UK companies are now truly global with over 70 per cent of the FTSE 100’s earnings generated overseas.

We believe that the world economy, despite high levels of debt in the developed world, will once again regain its upward momentum and should avoid a Japanese style multi-year period of deflation.

To conclude, the UK stock market has undergone a multi-year de-rating, but during this period corporate profits have continued to make progress, albeit at lower than average levels.

Stock markets have recently performed strongly which we think is sustainable because we are starting from a reasonable valuation point and the world will continue to expand creating economic growth and corporate dividend growth.

The severity of the Financial Crisis has meant that economic recovery is taking longer than usual, and high levels of debt will result in lower growth, but if we believe in history, equities will make good progress in this environment.

Robert Boddington is partner and chief client officer at Sarasin & Partners

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