From time to time, in articles such as Your 2014 anti-forecast, The Value Perspective likes to remind visitors that, when all is said and done, there are only three drivers of total investment returns. These are the dividend received, real earnings growth and any rise or fall in valuation – that is, the change in a business’s price/earnings (PE) multiple.
As equity markets (at least those in the developed world) continue their broadly upward trend, clearly these valuation multiples have been expanding and so we thought it would be worth taking a closer look at one of the last times investors were similarly excited – the tail-end of the late 1990s technology boom – to see what lessons might be learned.
The two charts below show the annualised five-year returns you would have received subsequent to investing at the date on the horizontal axis – in other words, 2008 on the horizontal axis shows the returns made over the five-year period from 2008 to 2013. The line shows the total investment return made over that period and the shaded areas break this down into the contributions from dividends, earnings growth and PE change.
The first chart shows the returns for the whole market in this way. As you might expect, it shows that after the peak of the dot-com, for investments made between 1998 and 2000, total returns turned negative for a period – mostly due to declines in the PE multiple of the market. However from 2001 onwards five-year returns turned positive again as earnings per share growth rebounded until 2007 when the credit crunch hit.
Charts show data for MSCI Europe, provided by Morgan Stanley – dated July 2013
The next chart shows the same data for the fifth of the market with the highest valuations. The overall pattern is broadly similar to that for the whole market, but there are some key differences. First, the change in PE multiple plays a larger part in boosting total returns during the dotcom boom – for investments made from the early to mid 1990s.
Unfortunately when the dotcom bubble burst, it was these stocks with higher PEs that took much of the pain. As the second chart shows, the period of negative total returns they suffered went on for much longer than for the market as a whole and the return to normal of their PE multiples – as shown by the large pink area below the horizontal axis - continued to act as a drag on total returns for the next decade.
Most expensive quintile
Anyone who made the mistake of buying the most expensive companies suffered from this decade-long PE normalisation, which partly offset some really quite positive earnings growth as well as the contribution from dividends paid.
This is a key and common mistake people make when thinking about highly valued growth companies – even if their profit growth turns out to be above average this benefit is often muted by investors having paid far too much for them. The dotcom boom was as good an example of this as any.
All of which leads us to make the point that, this time around – as markets again rise and valuations again grow more expensive – if you do end up paying over the odds for a company, you are pretty much stuck. Either you have to sell up and take the hit straight away or you are condemned to hold and watch that entry-point valuation work against you for a period that, as we have seen, can be as long as a decade.