A pointer to higher returns

PORTFOLIO POINT: The Australian sharemarket is trading below its 50-year price-earnings average, and that signals we’re in good buying territory – barring unforeseen circumstances. 

As the Australian companies’ profit reporting season draws to a close, you might be wondering why always the fuss. The answer is that company earnings and forecast changes are the foundation elements that drive sharemarket returns.

If you have missed the key take-away from the latest earnings season it’s worth checking Adam Carr’s article this week A good earnings picture, which notes that the earnings picture is not as bad as what many believe. Most companies are still making money, confirming that the equity market, as a whole, has been oversold.

The local sharemarket often reacts positively when expectations are exceeded (like two years ago by jumping 10%), or negatively when not (like last year falling similarly). Here I uniquely share 50 years of Australian company earnings to help you understand how company earnings and related factors specifically drive your investment return. I’ll also share an important correlation between the price/earnings (P/E) ratio and subsequent investor returns and comment on the prospects for the future.

Your total return from investing in shares comes from two components: one, dividend income and two, change in share price, which both relate to earnings.

Firstly, dividends are paid from earnings. In Australia generally half of company profits are paid out to shareholders as dividends, though this can vary from nearly all (for income stocks) to nil (for growth stocks). The balance of unpaid earnings is retained within the company and invested to grow earnings further.

While some companies pay dividends from capital (or are forced to during difficult times), they can do this only temporarily or until investors and bankers boycott further raisings. Below is a great chart of company earnings and dividends since 1985 from AMP Capital Investors’ chief economist Shane Oliver (Figure 1) – this is also a reminder that dividends are far more stable than company share prices.

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Earnings are important secondly as company share prices are based on a multiple of them. That multiple (the price/earnings ratio or P/E) is high for companies with healthy earnings growth prospects and is lower for those whose profits are expected to stagnate or decline. When value investors spot an ugly duckling company with low earnings and P/E, they expect to be rewarded twice if the company can transform into a swan – once by earnings growth and secondly through a change in price multiple. The opposite happens when an expensive high growth, high P/E company and its earnings falter.

Over this most recent 50 years to June 2012, investors earned an 11.4% annualised total return from investing in companies that make up the broader Australian sharemarket. About 45% of this came from dividend income and the balance from growth in share prices. Specifically, dividend income averaged an annualised 5.1%. During market lows in the early 1970s it peaked at 10%, and during irrationally exuberant 1987 it declined to a stingy 2%. It is now about 5% before franking benefits.

The compound average annual increase in share prices was 6.3%, which expectedly closely matches the annual growth of company earnings of 6.5%. Over the long term, I expect the change in market P/E to be small.

Figure 2 shows companies in the All Ordinaries index: their earnings (top), 12 month trailing P/E (middle), and the multiplied resultant share price (bottom). Note the top and bottom charts use a logarithmic scale that linearises compound growth.

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Australian company earnings (E)

While Australian companies have been able to grow their profits over the long term at 6.5% annually, this hasn’t been consistent. Indeed chartists can spot a 10-year pattern of seven-year long spurts of high growth followed by sputters of decline lasting two to three years. During the four boom periods (1963-71, 73-80, 83-90, 00 -07) corporate profits grew at a very high annualised 15% rate. Not surprisingly, these growth periods followed buoyant economic cycles. The black triangles indicate recessionary GDP declines, which most of the time marked the end of corporate profit rallies.

The first, second and fourth periods of high profit growth coincided with commodity price booms. The first when Australia resourced expanding Japan, the second was an energy boom following the oil price shocks of the early 1970s, and the latest was Australia resourcing China. The latter was also supported by a boom in bank lending and profits, who unlike earlier now make up an equal component of the market.

In the 1980s financials made up 10% of the Australian sharemarket and now are more than 30%, matching the contribution from resource companies. The mid to late 1980s boom in Australian company earnings can be linked to productivity improvements from economic reforms of the Hawke/Keating governments – which is why many are calling for a return to this focus as the resource and lending booms wind down. Note the strong earnings growth of the mid to late 1970s is decaffeinated if expressed in real terms, adjusting for unfriendly high inflation.

The period between the deep 1993 and short 2001 recession was unusual as there was very little profit growth in Australia. This was because of the absence of a strong commodity rally to support our dominant resource companies’ profits. Instead, globally there was a technology stock (.com) rally which bypassed us. Unfortunately we could see a repeat of this in the years ahead, with falling commodity prices and weak bank lending growth and margin erosion.

You’ll note from the top and bottom charts in Figure 2 that many of the rallies in corporate earnings translated into improved share prices, but not always. To understand why, we need to look also at the P/E multiple.

Prices investors pay to buy earnings (P/E)

The 50-year average price-to-earnings ratio, or the multiple of earnings investors are willing to pay to own the profits of Australian companies, is 13.5. This has varied from a low of 6.4 in 1974 to a high of 23 in heady 1999. The market P/E finished the recent 2011-12 financial year at 12.4, and hit a low of 8.2 in January 2009 during the GFC.

It is important to note the P/E ratio can spike upwards during sharp earnings collapses like in 1972 and 1993. This happens mathematically if more stable share prices are divided by a much smaller earnings number – it doesn’t always mean investors crazily overpay for earnings, it just means they are patient.

To reduce this sensitivity, P/E ratios are often based on the average of earnings for the last 12 months. Since this is a backward measure, analysts also look at forward earnings and calculate a different and generally more attractive lower P/E ratio (based on a higher future earnings divisor). Make sure you know which one is being referred to when comparing this data. At the moment the forward P/E of the market is about 11 compared to a decade average of 13.

It is worth pointing out that for the boom five years preceding the November 2007 GFC shares collapse, the market P/E was a stable 15. This, being the historic average, means investors were not overpaying for earnings – unlike investors in August 1987, who paid 21 times for earnings just prior to the October 1987 share price collapse. In retrospect it is just that those rapidly growing earnings were fuelled by debt-funded consumption, which came abruptly to a halt when credit froze.

The current 35% decline in share prices since 2007 can be explained by both a 20% drop in company earnings and a 20% drop in P/E. The sharp P/E drop in 2009 was driven by forced institutional and geared investor selling.

P/E can change over time, and a rising P/E provides a tailwind to share prices and a declining P/E a headwind. Figure 2 shows a pattern of (1), P/E decline to 1978, then (2), a long 21-year rise to 1999, and lastly (3), a decline since.

The below table summarises investor returns during these three periods and shows the competing effects of P/E and earnings change, which drove significant differences in investor returns.

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Even though companies bought in 1962 grew profits at 10% annually for the next 15 years, this translated into only a modest 4% price return because the market P/E fell by a half. On the other hand, new investors in 1979 enjoyed an above average annual share market return of 15% to 1998 - this despite anaemic annual corporate profit growth of 3.5%. This because they could resell companies at an expensive 18-21 times multiple, bought 21 years earlier on 6-7 times multiples. While Australian company earnings have grown since 1998 at the market average 6-7%, investors’ appetite for shares has fallen, driving down the P/E from 20 to 12 or by 40%. This mainly drove the below average 8% share market return for the last 14 years.

This leads to a very important lesson: the price or P/E at which you buy into the share market is a large driver of your future investment return. Generally speaking the lower or cheaper starting P/E you buy into the market, the more likely it is you will enjoy a higher future return on your money. To see how this is done in the US, click here.

Shown below, I think the first time, is the same relationship for the Australian share market. Here depicted is the annualized return to an Australian investor after 10 years depending on the P/E ratio at the time of their initial investment. Note this is without complex 10 year earnings averaging and inflation adjustment. I’ve calculated a 10 year, not 20 year, average return as I have “only” 50 years of company earnings to work with. Nevertheless it similarly shows that generally the lower price (P/E) you enter the market, the more likely is the chance you will enjoy a higher future return.

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This relationship broke down for investors in the early and mid-1960s who encountered unexpectedly poor returns when their 10 year journey finished right in the deep and prolonged 1970s crises and P/E chasm. The same disappointing return outcome befell new investors in 1997 to 2002 but as they started with a higher P/E that was more expected.

An optimistic conclusion from this relationship is that your future investment return for investing now (or staying invested) while the market P/E is about 12-13, is likely to be higher than it was for investors who invested within the last 25 years when P/E ratios were higher. 

Share prices (P = E x P/E)

By now hopefully you get that the trend in share prices as shown in the bottom part of Figure 2, is simply the trend in corporate earnings (top chart) multiplied by the trend in the P/E ratio (middle chart). When both trend up, share prices soar (like from 1973 to 1993 bar a 1987 interruption). When both are down, share prices plummet (like during the recent GFC). When both go in opposite directions, share prices generally stay flat (like in the 1960s). When the P/E is stable, then earnings growth drives share price alone (like prior to the GFC).

It has been suggested earnings are the fundamental driver of share prices (and dividends), while the P/E is the emotional driver. The latter however can also be influenced by other factors like interest rates which in investment terms are equivalent of your next best offer. Especially for the more diversified US market (and maybe less resources focused), rising interest rates usually depress P/E and vice versa. With interest rates so low, investors should actually be paying more for income (or a higher P/E) driving down the dividend % yield. The fact that isn’t happening right now is because of the massive fear of further equity declines. Once that fear abates, even if interest rates stay low and company profits stagnate, higher share prices with lower dividends are expected. The only caveat would be if sideburns and even lower P/E ratios from the early 1970s make a comeback.

Mid 2012 earning season link

Going into this earnings season analysts were expecting aggregate earnings to fall about 5% then rise 10% each in 2013 and 2014 – the latter are conservative estimates compared to usual 15% post-recession growth discussed earlier. Expected earnings depend more than usual on government policy decisions including local interest rates, offshore quantitative easing, debt support and other stimulus. Also the Australian dollar plays a big role for exporting miners and energy producers whose profits are tied to US$ commodity prices. In other words, future earnings are harder to predict.

If you think that profit growth will remain sluggish and the Australia dollar will change little, then in the absence of a major sentimental shift in P/E, share prices should remain flat for longer. If on the other hand you believe that a recovery in earnings is natural and/or a low P/E is unnatural, then you have reason to be optimistic. I think …

Dr Doug Turek is managing director of Family Wealth Advisory and Money Manager, Professional Wealth (www.professionalwealth.com.au).