'Read history! Read history! Read history!’ Charlie Munger
While investing is all about the future, having a solid understanding of the past can provide clarity and confidence when dealing with the future. Even the great investors understand that whilst investing is all about putting money down today with an expectation that you will earn more tomorrow, the forces that have driven historical success in the markets; things such as innovation, industrialisation and capitalism, haven’t changed. They are as relevant today as they were fifty years ago. And in that context, a recent paper by Thomas Mathews and published by the Reserve Bank of Australia entitled ‘A History of Australian Equities’, provides some interesting insights into Australia’s equity markets over the last 100 or so years.
While many people think of equities as the risky asset class, over the long term, the returns on equities has dwarfed so-called ‘safe-haven assets’ like bonds, cash and gold. While the RBA paper doesn’t delve into the latter two assets, we can complement the RBA’s work with research done by Professor Siegel of the Wharton Business School, that traces the returns on each of these asset classes and US equities over the last 200 years.
So how did Australian equities perform over the last 100 or so years? If we had invested $100 Australian dollars into the stock market in 1917 what would the value of our investment be today?
The table above shows that the total return for all Australian shares between 1917 and 2019 was 10.2% pa. This compares to the return on 10-year government bonds of 6.2% pa. It doesn’t sound like much of a difference right? Both asset classes delivered returns well in excess of inflation, 3.9% pa, such that each investors purchasing power was enhanced. In contrast, those that kept their cash under the mattress lost 3.9% pa in purchasing power due to inflation.
What’s not shown in the RBA paper is the impact these annual returns would produce in terms of compounded return by 2019. In his 1964 Partnership letter, Warren Buffett made the following observation:
“It is obvious that a variation of merely a few percentage points has an enormous effect on the success of a compounding (investment) program. It is also obvious that this effect mushrooms as the period lengthens.” Warren Buffett
So if Australian equities, over the last 102 years, returned a c.4% pa premium compared to government bonds, can you guess what $100 invested in each asset class in 1917 would produce in 2019? The answer is a staggering $2,000,000 in equities versus $46,200 in government bonds. That 4% pa additional return left equity holders with 43 times more money than the government bond holders. No wonder Einstein referred to compounding as the ‘Eighth Wonder of the World’.
The long term returns from Australian equities are remarkably similar to those of US equities. Data from Professor Siegel show the annualised return from US Equities between January 1917 and January 2018 was 10.0% pa with a standard deviation of 19.7% pa. This compares to the 10.2% pa return and 19.2% pa standard deviation from Australian equities.
The RBA paper highlighted the stock market was more volatile over the short to medium term, with a standard deviation of 19.2% pa versus 7.6% pa for bonds. Over the long term, stock market returns tend to mirror the earnings of the companies that make up the indices. Sir John Templeton observed "In the long run, the stock market indexes fluctuate around the long-term upward trend of earnings per share”. It provides a level of comfort that over the long term, earnings of Australian companies have grown at a similar rate to the compounded annualised rate of return on equities. The RBA paper found:
“Listed company profits have grown by an average of around 10 per cent per year since 1937” RBA
While a 100 year timeframe is not relevant for the average investor, 10 years is. The RBA paper provides a chart showing the 10 year trailing annualised returns for all shares, financials, resources and other sectors since the 1920’s. The chart clearly shows that for those investors who adopted a 10 year time frame, the annualised returns for all shares was negative just once in the 1970’s and this return was only around -5%.
Given the solid returns equities have produced since the Financial Crisis, many investors are now worried the Australian share market is over-valued and due for a correction. The RBA paper provides some comfort in this respect. The RBA found:
‘The current ratio for the top 100 stocks is within 10 basis points of its average since 1937” RBA
This is in stark contrast to Australian Government bonds. While government bonds have provided a historic return of 6.2% pa, they did so with the benefit of much higher dividend yields. The table below shows that Australian bonds yields are now at historic lows.
It’s clear that equities have produced far superior returns to bonds over time and that taking a longer term view for your investment portfolio is a recipe for success. Using a historical perspective, in its paper, the RBA data suggests that the market is not over valued in a historical context, and relative to bond yields the stock market is actually quite cheap.