Originally published in the anniversary edition of The Financial Express
As an employee of a stock brokerage I often find myself in situations where people want investment advice. This has to be a Bangladeshi investment analyst’s worst nightmare. It is a clear case of ‘heads I win, tails you lose’ because if the advice works no credit will be given to the analyst. If it doesn’t, then may God help the analyst.
Apart from the fact that there are conflicts of interest in giving such advice, it is also impossible to make people happy. The primary culprit is the massively inflated return expectations from stock market. Most people come to invest in the stock market thinking that doubling or tripling the money in one or two years is a ‘natural phenomenon’.
What is even more baffling is that these expectations are largely irrespective of education level. I have found a surprising number of highly qualified and educated people who behave like the average retail investor. The moment they decide to invest in the capital market they seem to lose their sanity.
Not surprisingly, many of these investors have to leave the market with their dreams broken. It is not very difficult to understand why. To make abnormal profits these investors have to resort to abnormal speculation. In the speculation game, only a few people win while the rest lose out in the long run. These few happen to be the people with inside information and syndicates using pump and dump strategies through spreading of rumors. The illusion of wealth creation that happens every now and then doesn’t take much long to fall like a house of cards.
The aim of this write-up is to use logic and reasoning to figure out what kind of returns a ‘sane’ investor should expect. Let me start with the basic theory. Over the long term or a business cycle (let us define long term as 10 years or more) the stock market returns should mirror the earnings growth of companies. The earnings growth of companies in the stock market can in turn mirror the Nominal GDP growth of the country (if the listed universe is a good representation of the economy). The Nominal GDP growth is nothing but the growth in national income. In the case of Bangladesh the Nominal GDP Growth has been ranging from 12-14% (Assuming 6% Real Growth and 6-8% inflation) for the last decade or so.
If we want to be a bit more optimistic we can say that the earnings growth for the listed universe can perhaps exceed the 12-14% and be around 16-20%. This can happen if the companies in the stock market are of better quality than the average company in the country. Thus they can outperform the national average. Using this logic, the return that the average investor can expect from the market should also be around 16-20%.
Now let us look at what the actual numbers tell us. Earnings growth for a sample of 156 companies that had profit figures from 2001-2013 had been around 19.1% per year. We can also look at what the market has returned in the past. The broader market has returned around 22.9% (Calculation done by BRAC EPL Stock Brokerage based on own proprietary index) per year from 2001-2013. This indicates that there was a small expansion of the P/E multiple. Nevertheless, the market gain per year was fairly close to the earnings growth. While historical returns are not always a good representation of the future it does give a rough idea.
Our investors are however not happy with 19-22% return and instead wants 100% return. Mathematically, that is impossible. Only the exceptionally talented and brilliant investors, insider traders (those who trade on inside information) and market manipulators will the ones getting higher than average returns. The rest of the group will earn below average return while an unfortunate subset will lose money.
Beating the averages (for almost any sector) is not as easy as it sounds. Under all circumstances, some sort of a competitive edge is required to do that. Let me give the example of a manufacturing company producing toys trying to beat its competitors. To be able to earn a return higher than the industry average (and its cost of capital) it needs to have some competitive advantage in the form of higher pricing power, lower cost, higher capital turnover etc.
The same logic applies to stock investment as well. To beat the market consistently one needs to have a sustained competitive advantage over the other market participants. Access to information (aka rumors), the primary tool of most of the retail investor is NOT a sustainable competitive advantage.In most times almost all other market participants have that information at the same time. By the time one usually acts on the information, the smart guys start getting out.
‘Inside information’ however does give an edge and research into other markets has proven that. That however is illegal. The only legal way to earn high returns over the long term lies by becoming an exceptionally talented analyst who is adept at finding market mispricing. That usually needs dedication and hard work. We usually say that it takes 4-5 years for someone to become a decent analyst.
Even then, almost no sane person should really expect more than 30-35% return in the long term horizon. But even before someone strives to become a great analyst it is necessary to make rational return expectations. That is the starting point for any Investment Policy Statement. Expert financial advisors in developed nations design client portfolio’s based on the return (and risk) expectations.
I do agree that as equities are riskier than other investment vehicles like fixed deposits, government bonds, land etc the return expectations should be a higher as well. Research on the risk premiums for the US market from 1926 to 1998 has shown that Equity Risk Premiums have been around 6.1%. Similar studies done globally have also given numbers in that range. Even going by that principle we get a return of around 17% at the current risk free rate of close to 11% (using ten year government bond yields).
What most people forget is that a few percentage point out-performance is actually a fairly big deal by itself. The difference between a 9%, 12% and a 15% return in a period of ten years can lead to vastly difference levels of wealth. This is the power and magic of compounding. The chart above indicates the beginning and ending value of a portfolio of BDT 1 mn. 9% return (close to the 1 year term deposit rate) can increase the wealth 2.37 times in 10 years. Compared to that a 15% return increases wealth 4.05 times and a 20% return 6.19 times.
We can also look at some of the most legendary stock investors of the world. The most famous investor Warren Buffet had an annualized return of 18%. Others like Peter Lynch and George Soros (While running the Quantum fund) achieved around 29-30%. Beating the market consistently is a rare feat that only a select few has achieved in the world.
In light of this information, I thoroughly feel that most Bangladeshi investors need to reassess and lower their expectations. Otherwise, they will not only continue to generate subpar returns but in many cases will lose their hard earned savings. This is surely the first step to getting out of the rumor based speculation and really getting the benefit of the asset class which has generated the most returns for investors in the world.