|Summary: Equities provided the best returns this year, but for local investors the best returns were offshore … and unhedged was the way to go. Interestingly, the main driver for shares was the demand for yield. The rise in share prices was certainly not reflected by improvements in earnings.|
|Key take-out: After years of outperformance and despite wonderful franking credits, investors need to have investments offshore to avoid periods of local underperformance and compensate themselves for a fall in the Australian dollar.|
|Key beneficiaries: General investors. Category: Investment strategy.|
Come January you’ll probably be setting your mind to how 2014 will unfold rather than studying what 2013 can teach you about investing.
So rather than wait, here is a critical appraisal about how the various asset classes propelled, or didn’t propel, your portfolio forward in 2013. In January, part two of this article (2014: The year that will be) will focus on what investors might expect from the various asset classes for 2014 and what consequences this will have for your portfolio mix.
Major asset class performance
Figure 1 below depicts how $1 invested in the major asset classes would have grown from January 1 this year to December 18. Also shown is the change in the Australian dollar, which started the year at $US1.04 to the US dollar (shown adjusted starting at $1). As of today it was trading below US89 cents. This 15% drop provided extra fuel to international equity investments – that is, provided you didn’t hedge out changes in currency. However, even if you did, you would have still made more money investing in companies listed offshore than onshore. This is a continuation of a three-year trend of underperformance of the broader Australian sharemarket (returning about 10% annually) versus international shares (16% annually). We’ll see later this is due to underperformance of Australian resources companies and banks.
The recent fall in the Australian dollar has also scared off foreign investors in our local market. Since November 1, the broader Australian sharemarket has fallen more than 6% while international sharemarkets fell only 2%, and by just 1% measured in Australian dollars. This should be no surprise. If you’re an overseas investor, why buy Australian shares at US95 cents in November if you can buy them later for US85 cents, according to the Reserve Bank’s governor Glenn Stevens. Perhaps this is another thing for Australian investors to feel repressed about?
Listed commercial property was on track to provide a third year of double-digit returns, but that now looks doubtful for local properties and possibly for those bought offshore, even with a weakening Australian dollar. Along with its high-yielding inflation-protecting cousin, global infrastructure (shown later) has been in demand as a “bond substitute”. Rents, tolls and utility company profits haven’t gone up 10% plus a year for three years; it’s just that investor demand for these assets has risen.
This explanation also underlies the stellar returns from share investing this year. While company profits only increased by single digits, double-digit share price growth is explained by increasing share demand. The price investors are willing to buy last year’s (trailing) company profits now is about 19 times profits (a lesser 18 for international shares) compared to about 15 times for both at the start of the year. That about 25% increase in price-earnings explains all of Australia’s share price return this year. In the New Year we’ll point out this isn’t sustainable, and the sharemarket is at best fairly valued now.
Unfortunately, defensive investors continue to be punished by central banks across the world intent on stimulating economies at their expense. They are doing this by (1) depressing interest rates below fair value and, in some parts of the world, (2) also buying bonds with digitally invented money (no, not crazy Bitcoins but crazier US dollars, UK pounds and Japanese yen). Bond buying pushes prices up and yields down. Bond traders have been so concerned about the tapering of this activity that they have been selling bonds in anticipation, contributing to worse-than-cash returns for bonds.
Before you take up your pitch fork to storm the RBA’s Martin Place fortress, perhaps you may take relative comfort knowing we are at least lucky in Australia to still enjoy break-even real returns on cash. Elsewhere in the developed world depositors are going backwards versus inflation by staying in cash. That reality has seen many move from cash and bonds back into shares, which in the US, UK and Europe at least provide a 2% (average) to 3% (high-yield) dividend income.
Others have also chased risky forms of credit, where I worry that they aren’t being sufficiently rewarded for the risk taken – which applies to you to if you are seeking out higher yields now late in this repression cycle.
Australian equities – yield and value in favour
Australian sharemarket returns aren’t uniform, and they vary among the difference sub-asset classes and industry sectors. This is shown in the following charts, which all rank the best to worst performers based on annual return’s to November 30, 2013. For a detailed summary of the industry make-up of the All Ordinaries or ASX index, read Goodbye to the All Ordinaries.
The “big” winners for 2013 were big high-yielding companies including the banks. Low priced “value” companies nearly doubled the returns of more expensive “growth” companies. Basically, those companies shunned during the more worrisome 2012 found love.
As an illustration of stock-specific risk, investors in non-discretionary consumer retail stock Crown have won big, earning 60%, while investors in competitor Echo Entertainment are out of the money by 40%. The sharemarket seems to think Echo’s profits are simply moving to Crown once Sydney’s new casino is built. If you own the index, this value shift doesn’t affect you. If you own Echo then, sorry, no one can hear your scream.
The sharemarket certainly believes the resources boom is over, although it was even more grim about investment prospects in July when shares were down 20% since January. They have since recovered to about par. The poor performance of Australian small companies reflects many of them being resource companies or those in the business of servicing them.
International equities – a treatment for dividend fever
Unlike in Australia, global small companies had a stellar year, up 50% to November 30. While 15% of this is currency effect, the balance is because of a love of new things risky. Low-priced value companies beat their growth counterparts. This is largely to be expected as the market earlier focused on safer defensive stocks, leaving these other asset classes under-priced and ripe for appreciation. In the US, for instance, the broader market, including lower dividend paying companies, performed better (returning 21% in US dollars) than expensive high dividend stocks (17%), as did value (22%) compared to growth stocks (17%). Investors outside Australia are no longer paying a premium for safer, high dividend stocks – which may be a signal for local investors for 2014 who also suffer dividend fever (See Beware of dividend fever).
In terms of regions, sharemarket investors believed the US was a stimulating place to invest, Europe must be recovering soon, but the strong fundamental growth in Asia isn’t worth paying a premium for. As pointed out in Re-emerging markets, in regards to emerging market companies, sometimes fundamentals aren’t matched by returns.
Fixed interest – financial repression continues
Returns from truly defensive assets in Australia have been meagre, which has especially hurt those investors who are overweight these safer assets.
However 2013 was a better year for depositors who aren’t familiar or comfortable with bonds. This year deposit rates roughly equalled or bettered bond yields. In prior years depositors earned less, not having bought bonds that profitably locked into higher rates that increased in value. This year bond investors suffered capital loss, which reduced their bonds’ already meagre yields. For instance, the broader Australian bond market returned about 1.6% (for the 12 months to November 30, 2013) even though it is currently yielding about 4% -- it suffered 2.4% of capital loss as investors decided the prices of bonds rose too high and yields were too small.
This effect was most pronounced the longer the maturity of the bonds owned. For instance, Australian Government bonds fixed for more than 10 years fell in value by about 10% (the market thinking interest rates should be 1% higher times 10 years, as a rule of thumb). Those bonds with an average maturity of five years fell about 4%, delivering a less than 1% return.
After providing double-digit returns for the last two to three years (and an 8% annual return including this negative year), inflation-linked bonds are on track to also provide a negative annual return. This is mainly due to these bonds also having a longer maturity, which makes them more sensitive in the short term to future interest rate and taper (reduced economic stimulus) changes. With the inflation outlook modest, investors have also stopped wanting to buy inflation protection. Perhaps this is a sale for inflation hawks?
Lastly, investors willing to take on the extra risk of hybrid/income securities were rewarded with an about 2% average premium return over much safer high-yield cash. This is expected in a risk dissipating year. A warning though. These premium returns can vanish when times turn tough. I hesitate to include them in this defensive investment category and often recommend you build your own hybrids (see Build your own hybrids).
A caution about drawing lessons from one-year of returns
Nobel Prize winning finance professor Eugene Fama often said that he needs 30 years of data before forming a conclusion – like he did about the long-term outperformance of value versus growth stocks and small versus large companies, for which he won his prize this year. So we need to be careful what we infer from looking at just one year of performance.
Perhaps 2013 reminds us then …
- Shares do recover after periods of gloom and even before optimism is well founded. Staying in cash and bonds too long can be expensive to your future returns.
- Fixed interest returns are more predictable and unfortunately more manipulated. They aren’t rewarding but are necessary to help you sleep better at night than investing in less reliable shares.
- Markets have a tendency to “mean revert”. In other words, what was pricey and in demand won’t stay that way for too long.
- It’s quite hard for an individual investor to pick the various winning asset classes. Instead, investors should diversify their portfolio to not miss out and absorb the bumps.
- Being a loyal Australian investor is not always profitable. After years of outperformance and despite wonderful franking credits, investors need to have investments offshore to avoid periods of local underperformance and compensate themselves for a fall in the Australian dollar (which will one day lead to higher local inflation).
Without 20/20 perfect hindsight, I look forward to sharing my views on how 2014 will unfold in the New Year in the second part of this article.
Since buoyant sharemarket returns arose mainly from one-off repricing, not earnings growth, you may need to temper your enthusiasm for a continuation of generous past buoyant equity returns.
Locally, our hope for a Santa Clause sharemarket rally seems to be starting with us being “Scrooged”. I hope this doesn’t continue and I wish you and your family the best for the holidays and a prosperous 2014.
Doug Turek is Managing Director of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au)