Brent Sheather: Testing the herd mentality

A fortnight ago, we looked at the first half of an article by United States finance academic and fund manager Clifford Asness.

The article was written for a forthcoming issue of the Financial Analysts Journal and is of interest because it challenges many of the commonly held views on investing.

Last time, Asness criticised the tendency of investors to choose sectors, like the US or emerging markets, on historic performance.

We also read that, while fund managers say that timing your purchase of shares is not important and everything will turn out okay in the long term, reality can be different. If you buy when prices are high, you may have to wait 10 years or more just to beat inflation.

This week, Asness shows us why dividends are good, what present high US stock prices tell us about future returns, that do-it-yourself trading is generally a bad idea and, finally, perhaps with Michael Cullen in mind, why international diversification is not a waste of time.

Dividends are good and for some surprising reasons.

Occasionally, commentators say New Zealand companies pay out much more of their profits as dividends when they should be reinvesting for growth.

Telecom pays out the majority of its earnings. Bad say the critics - can't it find anything to invest in profitably? The implication is that shareholders would be better off if companies cut dividends and reinvested profits.

Cullen and his tax vigilantes jump on this idea when they suggest clever investors buy overseas companies paying little or no dividends and, because there is no capital gains tax, rip off the system.

Well that sounds like a great scam, but that is simply not supported by the facts, which show that companies that pay out lots in dividends actually grow their future earnings faster than those with low payout ratios.

Asness adds: "Conversely, when firms pay out small dividends it means they either know they are running on fumes and cannot maintain a large cash payment or are often engaged in what can be called 'empire building'."

Since Telecom started distributing its profits, rather than spending them on Australian diversions, its shareprice performance has improved markedly.

It's interesting to see payout ratios increasing in the US, Europe and Asia as per the New Zealand example.

Today's high stock prices have two different meanings.

Asness is being a little humorous here in saying that the high level of the US stockmarket could mean one of two things - we should expect either low returns in the future or a big fall followed by average returns thereafter.

Either way, the outlook given the high valuation of US shares is not good. He explains that, in the past, there have been two reasons why shares have done badly when prices are high.

First, when stocks are expensive dividend yields are low, thus total returns are likely to be low.

Second, in the past when valuations have started out high, they have subsequently fallen. This latter effect, called mean reversion (that is, going back to the average), doesn't have to happen soon or indeed at any time. But if it doesn't happen we are stuck with high prices and low dividends as a percentage of these prices.

Either way, assuming shares are going to return 10 per cent in your savings plan is not logical even if you do invest with the help of a "fund manager of the year". Asness adds we have to assume that equities rise at about 6 per cent to 7 per cent a year.

Earnings do not grow at 10 per cent per year.

You would think, with so many highly-paid analysts forecasting company profits, that at the level of the overall economy things would be pretty accurate.

Not so unfortunately. Back in 1999/2000, the average five-year earnings growth forecast for the Nasdaq hit 30 per cent a year. On this basis, high prices looked reasonable, but when profits didn't jump by 30 per cent a year shares collapsed.

What is more, up until recently we didn't even have a good understanding of the long-term historic growth of earnings per share for the whole US stockmarket. Research shows that over the last 75 years, average earnings per share growth for the S&P500 has averaged inflation (3 per cent) plus 2 per cent or slightly lower than the rate of growth of the economy.

Amazing, is it not? The stockmarket, that fabulous growth machine, only produces an average 2 per cent real growth a year. In a flash, we see two things:

* The significance of dividends.

* The significance of fees.

Asness finishes with a prescient quote from Napoleon Bonaparte: "History is the version of past events people have decided to agree upon."

Do-it-yourself trading is a bad idea.

Here Asness warns against those advertisements telling individuals to take control of their own financial future by trading the stockmarket, usually on line.

Investing is not as simple as publications like Rich Dad, Poor Dad might suggest. There is evidence that professional active managers with degrees have difficulty beating low cost index funds. Asness ends this section with a quote from Quentin Crisp: "If at first you don't succeed, failure may be your style".

International diversification is not a waste of time.

Asness is answering critics of diversification from a US perspective who have questioned the practice by citing the tendency of the worst days, weeks and months for global equities to occur at the same time as the bad days for US stocks.

Asness agrees, but says that the real benefits of diversification accrue over longer periods than one month.

In this section, Asness shows that downside risk is minimised by diversification. He shows, using stockmarket performance data from 1950 to 2004, that the worst year for the five largest developed stockmarkets in the world averaged -52 per cent, whereas for the same years a portfolio equally diversified over the five markets returned -36 per cent. The worst 10 years for each of the five countries averaged -51.5 per cent. In the same period a global portfolio returned 21.5 per cent.

The longer the time period, the greater the benefits of diversity.

If international diversification, with its attendant costs and hassles, makes sense for American investors it has to be a good deal for mum and dad in Pukekohe.

* Brent Sheather is a Whakatane-based financial adviser