29 Apr 2019

Future NZ Equity returns - revisited

Regular readers might remember an article we wrote back in early 2016 on “predicting” future returns for the NZ equity market (see here). A bit of time has passed and the NZX index has gone from slightly over 6,000 at that point in 2016 to just topping 10,000 this week! We thought therefore it may be timely to see what has changed since that original analysis.

In our previous article on this topic we used the Grinold and Kroner model to break down future returns based on the following equation: 

ΔS  = Change in shares (new issuance less buybacks)
D/P  = Dividend yield
i  = Inflation
g  = Real earnings growth (not earnings per share)
ΔPE  = Change in Price to Earnings ratio

The beauty of this approach is you can then analyse each of these component parts in more detail. As we noted back in 2016 “some of these terms are known, some can be reasonably estimated and some…..well best left to the reader.”

Income yield 

As at end of 2015 the net dividend yield of the NZX 50 was 4.66%. Fast forward to the end of March 2019 and the net dividend yield of the NZX 50 is now 3.4%.  Since our prior analysis buybacks have diminished, being roughly $60m for NZX 50 companies over last 12 months. This equates to 0.06% of the market capitalisation of the NZX 50, which is now over $100bn.  We assumed a small amount of issuance over time of 0.1% last time and have no reason to change that figure so that gives ΔS of +0.04%.

Earnings growth

Inflation has stayed below the 2% figure we used in 2016 as shown in the chart below but given that the RBNZ band remains 1-3% we will stick with the same 2% assumption for now.

Source: https://www.rbnz.govt.nz/statistics/key-graphs/key-graph-inflation

For real earnings growth we assumed this should, over the long run at least, approximate real GDP growth. Otherwise it would result in corporate profits taking over the country or dwindling away. We can then further express it as follows:

                                                 Real Earnings growth @ Real GDP Growth = Labour force growth + Productivity

Labour force growth has not really changed since the analysis we did in 2016 (which is not surprising) so we will stick with using a figure of around 1% p.a.

Productivity stats have been updated since we did this prior and labour productivity has dropped off in 2017 and 2018 reducing average labour productivity to 1.0% for the current cycle (2008-2018) as per chart below:

Source: https://www.stats.govt.nz/information-releases/productivity-statistics-19782018

So, to summarise where we are at, before we add the repricing element, you have the following:

Repricing

As you can see from the table above, our starting point for future returns has deteriorated by nearly 2% over the last few years, which is not surprising given the strong returns the local market has produced.

This brings us to the last term of repricing, or change in P/E. This, as most investors know, can dominate equity returns in the short (and medium) term. Multiple components can contribute to changing PE ratios – inflation, discount rates etc. Though the hardest one to predict can be sentiment. Euphoria can push ratios unsustainably high and fear can drive them to unfeasible low numbers. The chart below (courtesy of Forsyth Barr) shows forward PE levels for the NZX market going back to 2005. As you can see the current level of 21.6 is over 5 points above the average for total period of 15.8x. Looking back further to 1992 the median PE is 14.2x so you could argue that even the 15.8x average is inflated.

We got a lot of positive feedback about the following table that allowed you, the reader, to predict where the PE ratio will end up and over what time frame. To recap, if you think the PE ratio will stay the same pick 0 in first column – to get a return of 7.4% p.a. If you think PE will drop by 3 points over 5 years then pick -3 in 1st column and 5 along top row to get an annual return of 4.1%.

The shaded red returns are less than current cash rate. Yellow is between cash and 7%. Green is a return above 7% per annum. 

To give a comparison the same table from 2016 is below

As you can see, to get a long-term return of 7% or more you must assume that the market PE stays at multi decade highs, or assume that earnings growth materially outpaces NZ GDP growth due to much stronger earnings from offshore focused companies e.g. A2 Milk.

In our opinion, these results suggest that active management is more important than ever. At this PE level we believe general market downside risk is elevated and long-term market return expectations should be moderate to low.  To protect against this risk, and generate a decent return you will need to be active.