Dec 09, 2022 | Tags: Investment
Our insights
Soaring inflation, surging interest rates and an unstable political climate the world over have combined to produce great uncertainty and volatility in equity markets.
But that doesn’t mean it’s time to stash your cash and turn your back on investment opportunities.
When there is turmoil in the marketplace, it is even more important to stick to a winning philosophy, remember to play the long game and not make the mistake of becoming reactive to sudden price swings.
At CWM, we focus on the four academically-backed primary drivers of investment market returns:
- Market
- Size
- Value
- Profitability
When applied, these drivers provide investment returns of up to 93%. Market forces such as momentum, greed and world events drive the remaining 7%.
Let’s look at each of them in a little more detail.
Market
Equities have a higher expected return over cash because of the higher level of risk.
That risk exists because:
- Dividends often fluctuate depending on profits unlike bond coupons.
- Shareholders have a residual claim whereas bondholders have a prior claim.
- Stock returns are prone to more volatility, although the risk is reduced the longer the term.
Measuring the size of that bigger return is known as the ‘equity risk premium’.
The most reliable way of calculating that risk is with a simple subtraction known as the ‘supply-side model’.
It is the difference between the expected return on stocks and the guaranteed return from bonds.
To make this a worthwhile comparison, it needs to be executed over an extended period, say 10 years, to eliminate the impact of short-term market fluctuations.
The figure also needs to be in ‘real’ terms i.e. net of inflation and after-tax.
That’s because investors will have to pay their marginal tax rate on bond coupons whereas shares held for more than 12 months will only attract that marginal rate on half of them, should they be sold at a profit.
Shareholders may also be paid fully-franked dividends.
Choosing to not invest at all and ‘stash’ your cash rather than buy equities is even more foolhardy than buying bonds, according to one of the world’s greatest investors, Warren Buffett.
He noted that across five decades from 1964-2014, the S & P 500 Index rose 11,196% with reinvested dividends.
That compares with cash under the mattress that actually fell in value by 87% because of inflation.
People associate volatility with risk according to Buffett but he argues the biggest risk is not to invest, because inflation is as certain as death and taxes.
And equities prove to be the only investment that consistently outrun inflation.
Size
Within equities, smaller companies generally outperform larger companies and have a higher expected return.
This is known as the ‘small firm effect’.
‘Small-cap’ companies are designated as those with a market value of less than $2 billion.
They are generally startups or small-capitalisation firms with potential for high growth.
They also normally have much lower stock prices, meaning the potential exists for much greater profit through share price appreciation, which can sometimes be triggered when a funding deficiency is addressed.
Small-cap companies with a share price of less than $5 may be more versatile in challenging economic climates.
On the downside, they may be prone to more price volatility and the risk of losing your investment if the business fails.
An intimate understanding of a small-cap business and its vision along with a proven business model can help guard against making the wrong choice.
Value
Equities that trade at a price below their intrinsic value have a higher expected return.
Identifying undervalued stocks is not as simple as searching for those that have suffered a price dip.
They may be undervalued for a number of reasons including market corrections, cyclical fluctuations, bad press or sometimes even a lack of visibility, possibly a startup in an emerging market.
There are several strategies you can employ to find undervalued stocks.
One is to look at a company’s price-to-earnings (PE) ratio.
This can be calculated by dividing the company’s share price by its earnings per share.
Its earnings per share can be discovered by dividing its earnings from the past 12 months by the number of shares held by stockholders.
In terms of value, the lower the PE ratio, the more potential value a stock has.
A company’s market capitalization (market cap or total value of the company’s shares) is also a good guide of a company’s profitability.
Simply multiply the company’s share price by the total number of shares held by stockholders.
Profitability
Companies with a history of being profitable are more likely to continue to be profitable in the future, and therefore have a higher expected return over time.
Profit is the primary goal of every company and critical to its future.
While companies may survive in the short term with a capital injection, no company can survive long term without turning a profit.
Hence, profitability is one of the key drivers of investment market return because profits are shared with shareholders by way of dividends.
To analyse a company’s profitability, you can calculate its profitability ratio from its income statement.
The profitability ratio reveals how successful a business is in earning profits compared with key metrics such as its operating costs, revenue and equity of shareholders.
The numbers can reveal potential problems or unseen costs in the business.
The higher the ratio, the more likely a company can sustain profits.
This in turn gives investors confidence in the company’s future.
The most important profitability ratio from an investors’ perspective is the Return on Equity (ROE) which is the percentage of net income relative to stockholders’ equity.
In other words, it’s the rate of return on the money invested in the business by shareholders.
Again, the higher the number, the better.
Get advice today
Volatile economic times often spook investors but it doesn’t have to be that way.
Smart investing remains the best way to guard against inflation and make real returns on your money.
But more than ever, it requires some astute decisions made off the back of some sound financial advice.
That’s whereCalder Wealth Management comes in.
CWM are financial experts who can help you make the best financial decisions for your long term interests.
There really is no substitute for quality financial advice from someone personally invested in your future.
At CWM, we pride ourselves on leading our clients into the future with structure, financial stability and confidence.
Contact ustoday to discuss all of your financial needs and concerns.
Written by Aaron Doig.
The information contained in this article is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.
Taxation, legal and other matters referred to on this website are of a general nature only and are based on Calder Wealth Management’s interpretation of laws existing at the time and should not be relied upon in place of appropriate professional advice. Those laws may change from time to time.
CWM specialises in wealth management with a focus on advice, investment, sustainability, insurance and finance.
