Equity markets: Shares and shibboleths

IF THERE is a sacred belief among investors, it is that equities are the best asset for the long run. Buy a diversified portfolio, be patient and rewards will come. Holding cash or government bonds may offer safety in the short term but leaves the investor at risk from inflation over longer periods.

Such beliefs sit oddly with the performance of the Tokyo stockmarket, which peaked at the end of 1989 and is still 75% below its high. Over the 30 years ending in 2010, a “long run” by any standards, American equities beat government bonds by less than a percentage point a year.

In the developed world, the period since the turn of the millennium has been a particular disappointment. Since the end of 1999 the return on American equities has been 7.6 percentage points a year lower than that on government bonds (see chart 1). That has left many corporate and public pension funds in deficit and many people with private pensions facing a delayed, or poorer, retirement. Understanding why equities have let investors down over the past decade will help them work out what to expect in the future.

The long-term faith in equities is based on the theory that investors should be rewarded for the riskiness of shares with a higher return, known as the “equity risk premium” (ERP). That risk comes in two forms. The first is that shareholders get paid only when other claimants on a company’s cashflow, such as workers, the taxman and creditors, have received their due. Profits and dividends are thus highly variable and can disappear altogether when times get tough. The second risk is that share prices are volatile, more so than bond prices. Since 1926 there have been seven calendar years when American equity investors have suffered a loss of more than 20%; investors in Treasuries have suffered no such calamitous years.

The big question, however, is how large that extra return should be. Here it is important to distinguish between the extra return investors actually achieved for holding equities (what could be called the ex post number) and the return they expected to achieve when they bought them (the ex ante figure). Academics started to focus on this problem in the mid-1980s when a paper by Rajnish Mehra and Edward Prescott indicated that the ex post return of American equity investors had been remarkably high, at around seven percentage points a year. It seems unlikely that investors expected to do so well.

Premium puzzle

There are a number of possible explanations for these very high ex post returns. One is survivorship bias in the numbers. America, which is the benchmark for ERP measurements, turned out to be the most successful economy of the 20th century, but it might not have been. Before the first world war investors doubtless had high hopes for Argentina, China or Russia—only to be disappointed.

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) have analysed the data for 19 countries from 1900 to 2011 and found that the ERP relative to Treasury bills (short-term government debt) ranged from just over two-and-a-half percentage points a year in Denmark to six-and-a-half points in Australia. They found a premium for America of five percentage points.

Another explanation for the high returns is a paradoxical one: that equities have become less risky. In the early part of the 20th century corporate accounts were more opaque and less reliable (though shareholders in Enron, a bust energy company, may disagree). Most stocks were owned by private investors with only a handful of individual shares. This left them more exposed to the risk of a single firm failing, which meant they put a lower value on shares—or, to put it another way, they demanded a higher premium for owning them.

Today most equities are owned by institutional investors who can assemble a diversified portfolio. Even small investors can own an index fund at low cost. The impact of one company failing is thus far smaller. This reduced risk has prompted investors to pay higher prices for shares; in other words, to accept a lower dividend yield. That may well have increased the ex post risk premium (other things being equal, a fall in the dividend yield from 4% to 2% means investors double their money).

The size and persistence of the ERP led some commentators in the late 1990s to come up with an ingenious, if flawed, argument. In their book “Dow 36,000”, for instance, James Glassman and Kevin Hassett argued that the reliable outperformance of shares over bonds meant that equities were not riskier at all. As a result, there need be no ex ante risk premium.

This time is not different

If this belief were correct, equity investors should have been willing to accept a lower earnings yield. (This is the inverse of the price-earnings ratio; if the p/e is 50, the earnings yield is 2%.) In the course of moving to the lower earnings yield, the market would have soared to the 36,000 level of the book’s title. A lower ex ante risk premium implies higher returns in the short term. The authors were proved right in one sense. Investors who bought shares in 1999 did not earn a risk premium. But that will be of scant consolation to those who believed the book, since 13 years later the Dow is at around 13,000, not 36,000.

One obvious problem with their reasoning was that, although equities might have beaten bonds over most long periods, the horizon of the average investor is much shorter. There have been many equity bear markets in history and investors are exposed to the real risk that they will have to sell in the middle of one. Most shares are owned by professional fund managers, who have to report to their clients every three months. If a big bet on equities goes wrong they cannot wait 20 years to be proved right. Clients will have deserted them long before then.

The late-1990s debate illustrated a familiar pattern at the top of bull markets. When share prices have already risen a lot, commentators scramble for reasons why they should rise even further. In the 1980s those who queried whether the Japanese stockmarket was expensive on a minimal dividend yield and a sky-high price-earnings ratio were told that “Western valuation methods” did not apply in Tokyo. At the turn of the century many assumed that, because the achieved ERP had been high in the past, it would be so in the future. But investors had their reasoning backwards. When share valuations are high, future returns are likely to be low and vice versa.

Given the history of the risk premium, what will the future reward for equity investors be? This question is discussed in a new set of papers* issued by the Chartered Financial Analysts Institute. The collection is a follow-up to a similar exercise undertaken in 2001, where the range of estimates of the premium varied from zero to seven percentage points a year.

The first step is to define the equity risk premium more exactly. Mssrs Dimson, Marsh and Staunton break it down into the following components: the dividend yield, plus the real dividend growth rate, plus or minus any change in the price/dividend ratio (the inverse of the dividend yield), minus the real risk-free interest rate.

In the period 1900-2011, the average world dividend yield was 4.1%; real dividend growth was just 0.8%; and the rerating of the market added 0.4%. That comes to a real equity return of 5.4% (the calculation is geometric, not arithmetic). Stripping out the risk-free interest rate, the ERP was 4.4% versus short-term government debt and 3.5% versus longer-term government bonds (see chart 2).

The dividend yield comprised the vast bulk of the return. This was true across all the countries studied by the authors. Had investors consistently bought the highest-yielding quintile of equity markets over the past 112 years they would have earned an average nominal annual return of 13.3% compared with a return of just 5.4% for those buying the lowest-yielding quintile. High-dividend markets have also performed best so far this century.

The importance of the dividend yield is ironic, given the lack of focus on the measure in most modern investment commentary. Many analysts argue that the dividend has been superseded by the share buy-back which (particularly in America) is a more tax-efficient way of returning cash to shareholders. But Robert Arnott of Research Affiliates points out that, although buy-backs reduce share capital, companies are also finding ways to add to it. Firms issue shares to pay for acquisitions, for example, or to reward executives through incentive schemes. Historically, net share issuance has been around 2% of total equity capital a year. This dilution of existing shareholders is part of the reason why real dividend growth has been so low, well below GDP growth.

As a starting point for estimating the future ERP, this is not encouraging. The current dividend yield on stockmarkets is lower (at 2.7% in the countries covered by the LBS data) than the historical average. Dividends tend to grow (at best) no faster than GDP, and usually slower because of the dilution effect. Nor is there much hope of a boost from a revaluation of the market. Since the yield is low, relative to history, it is more likely that any revaluation will subtract from returns. In another paper, Cliff Asness of AQR Capital, a hedge-fund group, uses his estimates of dividend yield and likely dividend growth to come up with a forecast for future real equity returns in America of around 4% a year.

Future imperfect

Although this figure is lower than the historical average, it still means that equity investors will earn a risk premium. The real yields on short- and long-term debt are zero, or negative in some cases. Nominal yields are close to historic lows. If the risk-free return is zero, then the entire return from equities will count as a risk premium. And a 4% premium would be only a little below the long-term average for America.

That still would not be high enough for many pension funds. In America, local-government pension funds base their contributions on the assumption that they will earn 8% (in nominal terms) on their investment portfolios. Treasury bonds yield 2% at the moment, so a 4% risk premium suggests a nominal return of 6% on equities. That means pension funds will fall well short of their targeted return.

Pension providers have two options: increase contributions or cut benefits. Cutting benefits will be difficult for many American states since pension rights are legally or constitutionally guaranteed. So taxes will have to go up or other services will have to be cut. Companies that have offered pensions linked to final salaries may have to divert money into their pension schemes, cash that could have been invested to boost the economy. Individuals who rely on private pensions (or on so-called defined-contribution benefits, where the company does not promise a payout) face the same problem.

Equities are not a miracle asset that will turn measly contributions into a generous pension. Those who want to retire in comfort should save more.

Source: http://www.economist.com/node/21550273

Don’t expect economic boost from cash-rich companies

Growth in the developed world will continue in 2012 to be hostage to the deleveraging process that is required to address the huge debts that piled up during the credit bubble. Yet the pattern is distributed unevenly across economies. In the US non-financial corporate sector, to take a striking case in point, the balance sheet recession has long been over. Profit margins are at record levels thanks to savage labour shedding and companies are awash with cash.

A similar accumulation of cash has occurred in Europe, though without comparable shrinkage in the workforce. Bin Jiang and Tim Koller of McKinsey estimate that European and US companies hold about $2tn of surplus cash, defined as the amount outstanding over and above operating cash, which is deemed to be two per cent of revenue. The question is how these cash balances will be deployed.

Ideally, companies should be investing, which would have the benign effect in current account deficit countries such as the UK and US of helping to rebalance the economy away from domestic consumption and public spending, and to jog them out of the habit of underinvesting relative to Germany, France and Japan. Yet this seems unlikely to happen. The effect of the recent credit bubble has been to bring forward many corporate spending decisions. This bunching of investment has been further exacerbated by the Obama administration’s investment tax breaks, now coming to an end. So it is a racing certainty that investment will fall sharply in the first half of the year in the US.

In Europe, meantime, the troubles of the eurozone banking system mean that a strong precautionary motive is at work. Many industrialists are hanging on to cash that earns very little interest because they fear that banks may be unable to finance their working capital requirements. The likelihood of recession in the eurozone likewise damps animal spirits.

Historically, profit margins have tended to revert to the mean, so excess cash may anyway dwindle. I suspect, too, that the English-speaking countries may be moving to a new, low-investment paradigm and not merely because, as in the case of the UK, they have a service sector bias. The practice of rewarding executives increasingly with equity is imposing a far greater focus on short-term measures of performance. Academic evidence in the US has, for example, shown that a high proportion of chief financial officers admits to a willingness to sacrifice economic value to meet short-term earnings targets. The current record profit margins and exceptionally high unemployment reflect that ruthless focus.

The capital market culture of these countries also has a strong emphasis on merger and acquisition activity which, from a managerial perspective, substitutes the thrill of the chase for the hard slog of managing operating businesses and investing in fixed capital. Business becomes transactional at the expense of relationships and performance is seen in narrowly financial terms. Far too many of the deals fail in economic terms, partly because stock options and rewards for failure give managers a huge incentive to bet the ranch.

That brings us to the most likely outlet for all that corporate cash. Much of it will go into share buy-backs, which are relatively painless for managers since, unlike dividends, they entail no continuing commitment to pay. Part of this activity will be arbitrage because corporate bond yields for many companies are now below the yields on equity.

This carries an interesting echo of the Japanese experience in the bubble of the 1980s. As the stock market soared, big corporations turned increasingly to financial engineering, using leverage to boost short-term earnings through speculation. That all ended in tears and a painful deleveraging process.

Charles Kindleberger, the economic historian, speculated that a shift in emphasis from production to consumption and a preoccupation with financial manipulation might be symptoms of national decline. That is hard to prove. Financial sophistication is arguably a natural accompaniment of advanced forms of capitalism.

Moreover, it is a mistake to consider investment as inherently virtuous. Japanese corporations have over-invested for decades and consequently shown poor returns on capital. Much the same is now happening in China, where investment is running at close to half gross domestic product. This is hugely wasteful and causes big distortions in global as well as domestic markets.

Yet it remains the case that the increasingly financial focus of anglophone business is not doing much for the ultimate shareholders, who are chiefly pension beneficiaries. The supposed alignment between the interests of managers and beneficiaries on the basis of stock options and other equity incentives is a fiction. Perhaps the poor equity returns of the past decade partly reflect that fact.

Source: http://www.ft.com/intl/cms/s/0/d7ff64c2-361f-11e1-9f98-00144feabdc0.html#axzz1iUVbDoKd

Not sharing: The coming shortage of equity investors

THE world has accumulated too much debt. Issuing more equity would reduce risk, particularly in the banking sector, and create the seed capital for new industries to emerge. But global investors may be losing their appetite for shares. That is the conclusion of a new report* by the McKinsey Global Institute, which argues that by 2020 a $12.3 trillion gap will have emerged between the amount of equity that needs to be supplied and the likely level of demand.

The problem is that investors in the developed world are shifting from equities into other assets, thanks to demographic changes, regulatory pressures and the disappointing returns suffered over the past ten years. Pension funds are maturing, with more of their members in retirement and fewer in work, so bonds are a more appropriate investment than equities. Insurance companies have shed equities in the face of regulations such as the European Union’s Solvency II regime; they could sell as much as $150 billion of shares over the next five years.

Meanwhile, the financial assets of developing-world investors are growing fast, but such investors tend to have a very small exposure to stockmarkets. Indians have only 8% of their wealth in equities. As they get richer, investors in the developing world will diversify their portfolios. But McKinsey estimates they would have to raise their equity allocations to the 42% owned by American households to close the gap completely.

Developing-world investors have understandable reasons for caution. Companies in emerging markets are often not as transparent as those in the developed world, nor do they have a record of treating minority shareholders well. Institutional investors—mutual funds, insurance companies, pension schemes—are not as well established in developing countries as they are in Europe and America.

Despite the subdued level of demand, companies will still need to issue equity, either to strengthen their balance sheets or to support their expansion. The banks will need to raise equity to meet the Basel rules. Meanwhile, the faster growth rate of developing countries means that more companies are likely to float on their domestic markets; more than half of all new issues in 2010, by volume and by value, were in emerging markets. Indeed, McKinsey reckons the net excess of supply over demand for equities in emerging markets will be some $7 trillion.

Now, of course, this gap is entirely notional. The actual level of equity supply and demand will exactly balance out. But if desired supply exceeds desired demand one of two things can happen. Share prices will fall, so that expected returns rise and investors become willing to buy shares again. This might happen if dividend yields on shares exceed government-bond yields for an extended period, as was the case in the first half of the 20th century.

It is also possible that governments can encourage greater demand for equities. In the developing world, that would require better protection for the small investor. In the developed world, tax-code reform is the big issue. Corporate interest payments are tax-deductible in most countries while dividends are not. But that would be a difficult reform to pull off. Given the state of public finances, governments are unlikely to be handing out new tax breaks. And removing the tax-deductibility of interest, even if it was accompanied by a lowering of the overall corporate-tax rate, would endanger the health of highly indebted companies.

The alternative possibility is that firms will eschew issuing equity and raise capital in the form of debt instead. There may well be an appetite for such paper, since government bond yields are so low (at least, in the likes of America, Britain and Germany) that investors will be attracted to the higher income offered by corporate bonds. But the risks ought to be obvious after the past few years. A highly geared economy is likely to suffer from bigger booms and bigger busts.

Equity is a very useful form of long-term capital for the corporate sector, and also offers a way for private investors to participate in the long-term growth of the economy. But in Europe and America, companies have been retiring equities through share buy-backs, while the volume of initial public offerings has dropped considerably from the peak years of 2000 and 2007. If the developed world is to recover its mojo, equity issuance has to come back into fashion.

Source: http://www.economist.com/node/21541424?fsrc=rss

Backlash from Netflix Buybacks

It is not Netflix's fault that investors priced its shares for perfection. But the Internet video company is to blame for managing its own balance sheet for the same flawless performance.

The former high-flier announced Monday night it had sold $200 million in new shares at $70 each and another $200 million in bonds convertible to stock at $85.80. Just months ago, the stock traded above $300. It is now at $72.



Netflix could easily have avoided this. The company has spent over $1 billion on share repurchases since 2007, leaving it with just $366 million in cash and $200 million in debt at the end of the third quarter. During that time, executives including chief executive Reed Hastings have been selling shares.

In buying back shares, Netflix failed to build a cash cushion against any slowdown in its heady growth rate. With expectations for healthy subscriber additions stretching into the future, the company locked into big contracts for streaming content. Since the start of 2011, the company has more than tripled such commitments to a whopping $3.5 billion, of which $2.9 billion is due in the next three years.

But everything changed this summer after the company raised prices and began bleeding subscribers. The company has not indicated subscriber losses have stopped and said it expects to lose money next year. Netflix has also said it expects free cash flow to lag net income over the next several quarters. In the year through September, the company's free cash flow was a modest $204 million, while buybacks totaled $200 million.

Unfortunately, dilutive stock and convertible issues have become Netflix's best option for raising cash to cover the potential outflows. The company sold $200 million in eight-year bonds in 2009, but those have a yield of about 7.3%, according to MarketAxess. So issuing more debt would mean large coupon payments. The newly-issued convertible doesn't include regular interest payments and won't mature until 2018.

What Netflix desperately needs is for streaming subscriber growth to resume. That should boost margins and cash flow, even though a portion of the content costs rise with viewership, because much of it was purchased for a fixed price. And if subscriptions improve, content owners could yet ask for higher fees in future deals, making a cash cushion crucial.

The lesson for growth companies is that buybacks can be risky—not just in large amounts, but at high prices. Netflix paid an average price of $45 a share for stock repurchased since 2007, below the current level of $72. But many of the recent purchases were at multiples of that price. If Netflix had refrained from aggressive buybacks until the business model was relatively steady, inevitable bumps in the road would have been much easier to ride out.

Source: http://online.wsj.com/article/SB10001424052970203710704577054431537105996.html?mod=WSJ_Heard_LEFTSecondNews