The grow slow years

For the past three years in the US and Europe, the bulk of equity returns have come from a re-rating to higher valuation levels rather than sales-led profits growth. In an environment where returns on cash and high quality government bonds are likely to remain low, investors continue to look to equities to deliver the returns required to cover long-term liabilities.

The problem is as acute for the largest institutional investors as it is for private investors saving for retirement. There is the cliché that what a wise man does in the beginning, a fool does in the end; we would have had much less of an issue with raising equity allocations in pension portfolios to offset declining income from cash and bonds when equities were at or below long-run valuation averages (i.e. 2009-2012). At present, with median price/book ratios at the very high end of 10-year ranges, Exhibit 1, the reach for yield strategy has clear dangers.

The demand for income – and growing income – has not gone unnoticed by the corporate sector. In the post-2008 era, corporates have been criticised for favouring shareholder returns (whether by dividends or share buybacks) over investment in organic growth. In aggregate, US and European companies appear much more eager to invest in the relative certainty of cost-cutting rather than investment in organic growth. This has translated into a significant decline in corporate sales growth on a global basis, Exhibit 2.

For investors, whether weak GDP growth is the cause – or effect – of weak growth in corporate revenues may be beside the point. The bare truth is that sales growth projections for equities in each of the UK, US and Europe are a fraction of the levels of earlier periods. For example, Exhibit 6 shows the average sales growth projection for the years 2006-09 by forecast date. Tracking this average expected growth over the forecasting period shows a relatively consistent level close to 8% pa, albeit with the traditional dip towards the right hand side of the chart when forecasts are trimmed to match reality. Exhibit 2 also shows the average sales growth for the period 2012-16. The stark difference is that forecast sales growth is one-half the pre-2008 period, at only 4%.

Why does this matter? First, we believe this may be a new normal due to slowing population and productivity growth trends. Consequently, these lower sales growth projections may be structural. Second, median equity valuations in the US and Europe have at the same time shifted significantly higher in recent years. In simplistic terms this may make sense, as dividend yields look more attractive as the yields on bonds move lower. However, this ignores the dividend growth factor, which is as important to the equity investor as the current yield because in the steady state, the equity return is equal to the current yield plus the growth rate of dividends.

For example, if the median growth rate of sales is only 3-4% and the median dividend yield is 2.5%, the long-run equity return from here would only be 5.5-6.5%, or levels achievable with lower-risk asset classes such as real estate.

There are of course two other levers that the corporate sector can use to increase cash returns to shareholders, even in the absence of revenue growth. Profit margins can be increased and payouts to shareholders made a greater proportion of net income. However, with both profit margins and dividend payouts close to the top of their historic ranges, the prospects for long-term dividend growth look rather discouraging for developed markets in the US, UK and Europe. We draw investors’ attention to the decline in the median dividend cover ratio in the UK over the last three years, Exhibit 3.

We certainly do not claim in this analysis that all companies or equity investments will disappoint investors, but instead highlight the risk for a disappointment in aggregate over the long term. Buy and hold may be a good strategy for avoiding the ups and downs of the stock market. In contrast, the strategy of hold and hope is less appealing.