Friday, November 21, 2008

Driving to the bottom

From Robert Bowerman's Smart Investing Blog

Are we there yet? Four simple words that every parent dreads as they head out the driveway for a long road trip with the youngsters safely belted up in the back seat. For investors the question is when will we arrive at the bottom of this particularly painful market cycle?

Respected Age newspaper columnist Malcolm Maiden - admittedly looking for silver linings - made the point during the week that with every 1% fall in the market we are 1% closer to the bottom.

With our sharemarket benchmark index falling through the psychologically telling 50% barrier the global financial crisis has now cost us more value in percentage terms than the 1987 share crash. In retrospect the 1987 crash was dramatic but short-lived and while it took time to recover and climb new highs a floor was relatively quickly found and stability returned.

With the Australian market having shed 20% this month it feels like we are accelerating to the bottom and there seems no clear reason why - given the relative strength of our banking system and economy.

But it is a good time to go back to fundamentals and the principles of long-term investing.

Jack Bogle, the founder of Vanguard and who is acknowledged as one of the great investment thinkers of our time advances a straightforward way for investors to understand what drives share market returns.

He argues there are three variables that explain nearly all of the return:
- The dividend yield at the time of initial investment
- The subsequent rate of growth in earnings
- The chance in price-earnings ratio during the period of investment.

Bogle argues that the dividend yield is a known quantity at the time you invest, while the rate of earnings growth has been relatively predictable within fairly narrow parameters. But the change in the price-earnings ratio has been highly speculative.

An investor's total return is simply the sum of those three factors so a dividend yield of 3% combined with forecast earnings growth of 5% gets you a return of 8%. If the price-earnings ratio added 2% you get a 10% return.

Bogle's message is that short-term investing effectively ignores dividend yield and earnings growth because both are relatively inconsequential in a period of weeks or months. In the four years up to November 2007 the "speculative" component of Bogle's return formula delivered extraordinary returns - in excess of dividends and earnings growth combined.

But that bubble has not so much burst as exploded. The price-earnings ratio of the Australian market is now just above 9 - down from a peak of 17.9 in October last year.

Perhaps more dramatic is to look at the yields on some of our banks and retailers - on November 21 NAB's dividend yield was above 10%, Westpac's yield was 9.2% and both had price/earnings ratios of 7.2. Major retailer Woolworths, in contrast, is sitting on a more normal yield of 3.7% and p/e ratio of 18. While Harvey Norman has a yield of 6.5% and a p/e of 6.3.

No-one knows for sure when we will arrive at the bottom but the fundamental signposts pointing to underlying economic value - which should be the basis for all long-term investing - is saying we are getting closer.

What we can be certain about is that there will be a bottom. We also know that governments around the globe are committed to stimulating economic activity.

So the options are simple: stop the car, invest in cash and curl up in the foetal position or grit your teeth, tune out the market noise and keep driving keeping a watchful eye on investing costs and your asset allocation.

Source: Common Sense on Mutual Funds by John C. Bogle.