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Last week, Ian wrote how Past Performance Is Not Indicative of Future Results, and this week we seek to take this line of thought one step further. It is well known that the local equity market has had an extended period of lackluster returns (ALSI 5 year return to 31 December 2018 = 5.8% pa), and many investors are now looking to throw in the towel. This article will seek to provide some context into where we have been and where we expect to go from here on out.

At the simplest level it is interesting to show that, in the past at least, all (5 year) periods of weak returns from the ALSI are followed by 5 years of strong returns. Chart 1, below, shows annualised ALSI returns for a specific 5 year period (grey line) superimposed with the subsequent 5 year annualised return (blue line). All poor return periods are highlighted with red circles, and the green circles show the subsequent 5-year returns.

Chart 1: ALSI Rolling 5 Year Returns

Source: Seed Investments (31 December 2018)

Markets generally don’t just generate good returns because of a period of poor returns. Rather, these periods of good returns typically come after periods of poor returns, because markets go from being expensive to cheaply valued (or at the very least less expensively valued). When looking, again, at the local market we can see in Chart 2, below, how its starting valuation (horizontal axis) has a large impact on the subsequent 5-year return (vertical axis). The grey dots each represent a starting valuation with the subsequent 5-year return, with the black dashed line giving the expected 5-year return for each valuation starting point.

It is very clear that the expected returns as at 31 December 2016 and 2017 were on the low end of the range, with the market PE approaching 20! During 2018 there was earnings growth while the equity market fell, which has resulted in a much better entry point for investors (green dot). While valuations have improved, it is also clear that investors shouldn’t expect outsized returns and that valuations could continue to improve (i.e. more market weakness).

Chart 2: Starting Market Valuation (PE Ratio) vs 5 Year (Expected) Return

Source: Seed Investments (31 December 2018)

Using various inputs, we have developed a model that guides us in setting our expectations for market returns. We then track this expected return versus the actual return achieved, which Chart 3 sets out below. The model has been fairly accurate but, like with any model, there will be times when it is too optimistic and times when it is too pessimistic. For the prior 5 years it was too optimistic (i.e. actual return achieved was below the expected return). Return expectations have been gradually improving over the past two and half years, with the current level the highest in nearly 6 years.

Again, this model doesn’t indicate that investors should expect outsized returns from here on out, but should be fairly confident to receive at least double-digit returns over the next 5 years (bearing in mind they don’t come in a straight line).

Chart 3: Local Equity Model – Expected vs Actual Return

Ultimately, it is important to understand how all this information flows into the construction of our portfolios. When deciding on the local equity allocation in the Seed Balanced Prescient Fund (our longest running unit trust and house view portfolio) the expected 5-year return is a key input. Chart 4, below, shows how the equity allocation is reduced when the expected return reduces and vice versa. As can be seen, there is quite a high correlation which is what should be expected from a well functioning investment process.

Chart 4: Seed Balanced Prescient Fund – Local Equity: Expected Return vs Weight

Source: Seed Investments (31 December 2018)

The Fund has benefited from having low equity exposure over the past 5 plus years, and for the first time since early 2013 the local equity weighting is above 45% and, should opportunities present themselves, the weighting could creep up some more.

Take care,

Mike Browne

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