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Benjamin Graham, the father of value investing and Warren Buffett’s mentor, is often quoted as saying, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” While most investors inherently understand that equity investing should be done with a long term horizon, it is very interesting how the above quote is actually reflected in market returns. By putting it into a few charts, we can far better appreciate just how relevant the quote is.

To show this I have broken the return of the ALSI into its 3 component parts, dividend yield, earnings growth, and PE change. The return generated from dividends is the most stable component of the return stream, followed by earnings growth. The change in the PE multiple is generally the most volatile component of an investor’s return and it is eye opening to see just how much of an impact it can make over the short term.

In Chart 1, the ALSI return is shown over rolling 1 year periods. We all intuitively know that investing into equities requires an investment horizon of longer than 1 year, and this chart shows exactly why this is the case. Aside from the fact that there are quite a few periods of negative returns, it is interesting to note that nearly half of the average ALSI 1 year return is determined by the change in PE ratio. Over 1 year, then, nearly half of your investment thesis comes down to your assessment of the change in popularity of your investment.

Chart 1: Rolling 1 Year ALSI Return (broken into component parts) Source: Seed Investments (31 January 2019)

When looking over 10 years, however, it becomes obvious that the major determinant of your return is not the price you paid, but rather whether your investment has delivered earnings and paid out dividends, i.e. quality investments rise to the top not because they become more popular (get voted for) but rather because they grow in value (get more weighty). Being more popular over this period certainly will help, but it is no longer just a popularity contest but more of a meritocracy. On average, less than one sixth of your 10 year return is determined by the change in the market PE ratio.

Chart 2: Rolling 10 Year ALSI Return (broken into component parts) Source: Seed Investments (31 January 2019)

Chart 3, below, shows how over 1 year your return is pretty much 50/50 split between fundamentals (dividends and earnings) and sentiment (valuation change) but how over 10 years more than 80% of your return is determined by fundamentals and less than 20% by sentiment. Get the odds in your favour by setting your investment horizon appropriately!

Chart 3: Return Split for Different Investment Horizons Source: Seed Investments (31 January 2019)

A few sharp investors are probably looking at the above and thinking, “Surely if I can determine the direction of earnings over the short term (next year), then this will be a major factor on the direction of the market PE ratio because investors should be happy if earnings are growing (and vice versa)?” Unfortunately, this assessment is not in the slightest bit accurate. In fact, over 1 year periods, 45% of the time the PE ratio is down AND earnings are up, as shown in Chart 4 below.

Chart 4: Prevalence of Different Market Environments Source: Seed Investments (31 January 2019)

The data in Table 1 shows that the average earnings growth is in fact stronger in periods when the PE ratio is down (19%) than when the PE ratio is up (18%). This invalidates any argument that it is mainly due to weak earnings growth that the PE falls. When looking at the average ALSI return in the 4 discussed scenarios, it is pretty evident how important the change in PE ratio is to 1 year returns.

Table 1: Selected Data over Rolling 1 Year Periods Source: Seed Investments (31 January 2019)

This insight filters through to our decision making process by ensuring that we make our investment decisions with appropriate investment horizons in place. I mentioned in my last report that our expectations for local equity returns are the highest that they have been for 6 years. While we expect decent returns this year from equity markets, we aren’t reliant on the market delivering returns this year.

Should there be more market weakness we have both the capacity and fortitude to take advantage of the improved valuations knowing full well that our decisions will pay off over the next 5 to 10 years.

Take care,

Mike Browne

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