The illustration below explains how to calculate the expected return from a share or the overall market, which is represented by the straight upward sloping line in the chart and is simply the current dividend yield + expected real (above inflation) earnings growth. The current ALSI dividend yield of 3.5% with an expected real earnings growth of 3% should provide investors with a 6.5% real return or 11.5% nominal return for the year.
Of course, this is an over-simplification, because as you know well the stock market never provides for a smooth return profile. In fact, the stock market return profile is more akin to bunging-off the tallest bridge in the world with frightening moves around the long-term average, both on the up and downside. This is crudely represented by the cyclical wave in the chart. I say crudely because the illustration makes the cycle look very predictable and smooth, which it is not. We have extreme peaks and troughs driven by a very powerful force in the collective greed and fear of investors.
The total return at any given time is the dividend yield + the earnings growth plus or minus the current sentiment or rating, which is referred to as a de-rating (minus) or re-rating (plus). At times when the sentiment is negative investors offer less for a share / business than it is worth and at times when sentiment is positive investors are happy to pay more for a share / business than it is worth. This seems nonsensical, why would you overpay for a business or sell a business for less than its worth, this is a very good question for which there is no clear-cut answer other than the irrational behaviour of investors.
Neuroscience studies have proven that investors experience financial loss as a mortal threat triggering an intuitive fight or flight response with no rational thought involved. We cannot help ourselves, our evolutionary “wiring” does not allow for it. Interestingly, studies have shown that we experience gains in the same part of the brain as that of taking cocaine.
The current dislocation between price and value for many out of favour businesses and markets is at extreme levels providing an opportunity for contrarian value investors, unfortunately to be a contrarian value investor you will have to bypass your evolutionary “wiring” and engage your rational brain, which is easier said than done. For the rest, just try not do anything stupid!
Mcomm, CFP®, HdipTax
T. 021-851 3746