Network Past Issues

 A matter of equity

In the current financial climate investors are advised to tread with caution 

Even as ‘Modi-fied’ Indian markets enter the elite $2 trillion club there is wisdom in exercising caution. This holds particularly true for those looking for excess returns on their earnings.

Looking at the history of excess returns, their hierarchy may be summed up in a quasi mathematical formula – roughly – as follows:

Small and mid-cap equities > largecap equities > bonds > treasury bills.

That is how it has been so far, right?

We have also seen long-term returns on small and mid-cap equity while large cap equities have been six to four percent higher compared to bonds. The reason for this difference lies in RISK, which embraces price, inflation, and fundamental risks. Ah, but then this is another article reserved for another issue of Network.

For now, let us look at the financial Physics, so to speak, in these exciting A matter of equity In the current financial climate investors are advised to tread with caution times. Did I say exciting? Oh yes, undoubtedly, but there is that (spoilsport) proverbial sting in the tail. Looking at future growth in earnings and dividends and inflation (EDI) the picture that emerges is one of nebulousness or uncertainty. This uncertainty is also the reason for higher compensation to owners of equity. It is expected, though, that the three factors subsumed under the EDI cipher will be lower than historical averages.

Let’s face it- equities ARE expensive at the present time. Indian equities (Nifty 50) are trading at +1 SD of average one year forward earnings’ multiple while US equities are trading at 30X (levels not seen since 1930) according to the Shiller’s CAPE model.

In the following paragraphs, I present arguments in the context of why equities will continue to be expensive while future relative returns could be lower.

So, what do we mean by ‘expensive equities’ really? It means that the cost of capital for its users is lower. Rather ironically, a diversified portfolio of equities carries very little risk; yet the market rewards equities with returns that are significantly higher than bonds. Compared to equity shares bonds tend to under-perform with a handful outperforming the former handsomely. It is the presence of these few stocks that cause equities to outperform bonds decisively.

The above is among the reasons assigned to the increasing popularity of passive investing, a tactic aimed at maximizing returns through minimized buying and selling. The average investor, realizing the difficulty of picking winners, has settled for a broad-based index to include all the winners.

What this means is that a diversified equity portfolio (with bond like risks) should not earn higher than four to six percent returns. Besides, the vastly reduced cost of diversification (brokerage + fund m a n a g e m e n t ) is likely to exert d o w n w a r d pressure on expected future returns. If the cost of diversification is lowered by two percent excess returns on equities are likely to be reduced concomitantly.

So, is passive investing a safer bet?

It may be safely asserted that passive investing has resulted in higher equity valuations. In developed countries ETFs or exchange traded funds and passive investing receive a higher percentage of incremental flows. It is very likely that we witness a similar phenomenon in India in the coming years- maybe a decade or somewhat later.

I also believe that investors have learned valuable lessons based on past experience. Today, they panic far less than they did a decade ago. Moreover, corporate payouts (dividend + buyback), too, are on the rise, even though they are higher by far in the US- 100 percent of one’s earnings versus a mere six percent in India. Whatever the percentage of returns let us not forget that corporate payouts do tend to soothe investor nerves.

Also, let us not forget that agencies like Central Banks and the Government increased their interventions whenever markets have gone awry. The presence of such major bodies reduces the risks associated with investing in equities. What this also means, however, is that equity share owners end up with reduced compensation.

For now, though, investors are advised to tread with caution. Caution, then, is the new financial buzzword.

The bottom line is clear: In future, equities will continue to outperform bonds, albeit to a lesser extent compared to the past.

By: Jyoti Prakash (PRM 5) Head of Equity, Aegon Life Insurance