Investing in stocks is full of uncertainties. There are loads of things that you can’t control. But there’s one thing that massively improves your chances as an investor. It’s a way to turbocharge profits. Let’s take a look at why, and one great opportunity in today’s markets.
Will the central bank raise interest rates? Which political party will win the next election? Will commodity prices rise and drive up inflation? Will there be a big terrorist attack soon? Will the country get hit by a natural disaster like an earthquake or hurricane? Will there be another banking crisis?
These kinds of questions are all valid things for investors to ponder. But the reality is that, most of the time, no amount of analysis will come up with reliable answers. At best it’s all guesswork, of the educated or uneducated kind.
The danger is that all this uncertainty leads to inaction. Many people, unsure what to do, end up putting all their savings into low return bank deposits. Others simply invest in an index of home country stocks, irrespective of whether that index has attractive prospects.
History shows that stocks are the best way to grow your wealth over time. By that, I mean increasing the value at a rate well above inflation, even after taxes are paid.
Findings in the Credit Suisse Global Investment Returns Yearbook 2016 clearly show this. For a group of 23 countries where continuous data is available, over the period 1900 to 2015 and measured in US dollars, stocks made a real (above inflation) return of 5% a year, compared with 1.8% for government bonds and just 0.8% for government bills, which are equivalent to cash deposits.
The same is true in most individual countries. The following chart shows the figures for a selection of countries.
There’s one essential thing to highlight here. None – and I mean not one – of the countries analysed had negative real returns on stocks in the long run, over the 1900 to 2015 period. Although in some cases bonds and cash had negative real returns.
I cannot stress enough how important this is. Investors must own stocks if they want to make decent returns on their savings and investments.
This is especially true in a world of ultra low, or even negative, yields on most bonds. We’re at the end of a multi-decade bull market in bonds, which has ended in a bubble.
In fact yields are the lowest they have been ever, meaning over several centuries. This leaves stocks as the only financial investment with the prospect of good future returns.
But the question is, which stocks?
Luckily, despite all the uncertainties, there’s one reliable way to turbocharge your stock profits. It massively increases the chances of reaping high future returns.
Of course it won’t work every single time. But applied consistently, and with patience, it’s the surest way to give a big boost to your portfolio.
Imagine that investors want to make 10% a year from a particular stock. That’s what they think they should get for the risk of owning a piece of that company. (In financial jargon it’s called the “cost of equity”.)
Now imagine that earnings grow by 5% a year, every year, and the number of shares is constant. That means earnings per share (EPS) will also go up 5% a year.
If the market P/E stays constant the price will go up 5% each year. That’s half the required return of 5%. The other half will come from dividends, meaning a 5% dividend yield is needed to bring total return up to 10%.
Next let’s say that fair value of this stock – what it’s actually worth – gives it a P/E of 10 times earnings. This depends on some underlying financial factors, but they’re not relevant to what I’m trying to show here.
If the stock price is the same as fair value, and stays that way, then the P/E will always be 10. Investors will make 10% a year – half from EPS growth and half from dividend yield.
But wait! A cunning investor, on the hunt for good deals, spots that the market price has a P/E of just 8, or a 20% discount. That means there’s 25% upside to fair value, also known as the “margin of safety”.
It also means the dividend yield is 25% higher, now at 6.25%. That’s because the company will pay out just the same amount of cash, but the share price is lower, making the yield higher.
Buying such a cheaply priced stock is a great profit opportunity. Company profit growth will still be 5% a year, as the company’s business hasn’t changed. But at this lower P/E the total annual investor profit has increased from 10% to 11.25%, because of the higher dividend yield.
Even better than that, there’s a high chance that other investors will eventually realise the stock is cheap. It will get bid up from a P/E of 8 to a P/E of 10 over a period of time. That’s an extra 25% of potential profit.
If it happens over 10 years, and if dividends are reinvested in more shares along the way, the total profit reaped by our cunning investor will be boosted to just over 13% a year.
(Calculating this is complex, but I managed it with the help of a spreadsheet. Also there could be income taxes on dividends in the real world, but the principle stays the same.)
This clearly shows why it’s important to buy well, when market valuation multiples are low. And also why it’s a bad idea to overpay, which has the opposite effect and depresses returns.
Now that I’ve explained how it works, let’s jump to the real world. Specifically, let’s look at my favourite discounted country stock market, Russia.
Russian stocks are up 28% this year, measured in US dollars, making it one of the world’s best performers. It’s also up 17% (plus dividends) in the year and a half since I recommended it in March 2015, having endured a tough 2015 (see here).
Despite the recent strong performance Russia is still a huge bargain that’s likely to deliver highly attractive returns to investors over coming years.
Now, I know that a great many people have a negative view of Russia and all things Russian. Apparently there’s no getting over the propaganda of the Cold War, even a quarter of a century after it ended. Unfortunately we are still served up a daily diet of negative stories in the mainstream media, or ridiculous statements about Russia made by politicians.
The country is constantly demonised. But the reality is that it’s been a great economic success story over the past 15 years or so, even if it’s in temporary recession at the moment. If you don’t believe me then I recommend a trip to Moscow or St. Petersburg to see for yourself!
The MSCI Russia index is set to have a dividend yield of over 7% next year, which is huge in a low yield world. The index has a low P/E ratio of about 7, and looks good for about 6% annual profit growth, based on underlying financials. That said it will depend on external factors like commodity prices. But 6% growth is pretty typical, so I’ll keep this assumption.
Adding together the dividends and profit growth, this means that investors in Russian stocks should make about 13% a year, even if the P/E doesn’t rise.
But what if market valuation multiples rise over time? By my calculations, at fair value the P/E should be somewhere around around 11.2, which is 61% higher than today. Even then Russian stocks would still have a dividend yield of 4.5%.
So let’s see what could happen if the P/E rises that much over ten years, as in my earlier example. Also with dividends reinvested, as before.
It works out as the equivalent of a compound annual return of 16.5% a year. That compares with the long run return on US stocks of a 9.5% a year.
In fact, if the P/E rises over a shorter time the annual return will be even bigger. In my experience big discounts usually disappear over 2-5 years. One way or another, buying Russian stocks looks like a great way to turbocharge future profits.
Of course we can’t know precisely what will happen in Russia in coming years. We don’t have crystal balls. But the place has been written off several times before in the past 20 years and has always come bouncing back.
There are few certainties in life, let alone in investing. But buying stocks when they’re deeply discounted – as offered in Russia today – makes the likelihood of big future profits much, much higher.
This is called “value investing”. It’s the most reliable way I know to turbocharge your stock profits, especially if you’re a private investor.
Add plenty of patience and enjoy the ride.
Stay tuned OfWealthers,
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