Founders have changed the world and will continue as long as capitalism exists. Our system motivates bright individuals to pursue dreams and build companies that improve human lives, just as trees in a canopy compete vertically for sunlight. For us investors, we need not miss out on these game changers. We can participate in the rise of these companies alongside their founders, and if analytical judgement is cast correctly, stand to benefit immensely from their journey.

Are all founder-led companies start ups?

Investing in founder-led companies does not mean venture capital investing - there are over 2,000 listed founder-led companies globally, varying in age, size and industry. Not all founders work on new and shiny products, only a small proportion are start ups. In fact there are many blue chip founder-led companies that are not in the technology sector, and these global household giants should resonate with many of my readers: Marriott, Morningstar, Hermes, Walmart and Nike.

What are the risks of founder-led companies?

The pros of investing in founder-led companies are well documented by academics and practitioners alike - Credit Suisse and Bain have quantified a +7% outperformance since 2006. Other studies show multi-decade alpha. In business, skin in the game matters and that is why founders make great business owners and operators.

But not all founders are great. Not all founder-led companies turn out to be the next Amazon. Hence everything in moderation, and why diversification is needed to dampen the volatility of owning just one company. This is where a clear portfolio construction recipe comes in.

I have previously likened portfolios to making a cake in this publication. We select our best ingredients and apply them in the right proportions before baking in an oven at the right temperature. What generates returns is not what has happened, but what will happen. And proportions are crucial.

Instead of baking one cake with all our cake mix and hoping it turns out well, we should divide the cake mix to make many cakes. With each cake we make, risk is reduced. That is the key to a well-balanced portfolio of founder-led companies. The sum of the parts is always greater than the whole, especially when it comes to risk management.

There is an optimal way to diversify and the framework for this process is tied with the concept of vintages.

How to diversify a portfolio of founder-led companies

The least volatile founder-led companies are also usually the oldest. Think Walmart, Hermes and Nike, who have each existed for decades. The advantage of these generational companies is stability of growth and predictability of dividends. They move like ocean liners, their brands carry an inertia that spins off free cash flow consistently. You can rely on these founder-led companies to deliver slow and steady growth to your portfolio. The advantages are not without risk though. Older generational companies can become complacent. Their founders may have already reaped the rewards of their lifetime of efforts and become content with sitting back and relaxing. Their succession planning may not be smooth. The companies themselves may not be built the right way to adapt to changing environments. Ocean liners have a huge turning circle; it becomes impossible to navigate fast-changing conditions when they have only been built to travel in straight lines.

This is why portfolios should be built to capture the full spectrum of founders from different vintages. You want both ocean liners and speedboats. Younger founders are hungry and motivated. They are free of the shackles imposed by legacy constraints. In this day and age, issues caused by use of outdated technology can prove significant for incumbents - you can observe how difficult it is for banks to transform their systems. It is easier and faster to build from scratch than it is to modify, much like how building a new house is faster than renovating an old building. When the pace of change increases, newcomers have the advantage.

Take for example a company my fund is invested in. It's a Dutch company called Adyen in the global payments market. They've been built with technology from the ground up that allows them to outcompete incumbents. As a result, they have been able to win significant market share in a very short period of time and capture the accelerating change in consumer payment behaviour.

When it comes to founder-led companies, there are pros and cons to both old and young. Having all your eggs in either one or the other would be unwise. Spread your portfolio across founders from all vintages. You want to build a fleet that encompasses the ocean liners, giving stability and reliability, and mix them with speedboats who can navigate changing environments and adapt with the times. This is what can truly mitigate risk.

Skin in the game - when theory meets practice

A final question and thought for my readers: which of these investment opportunities is inherently riskier over the long-term:

1)    Multinational blue chip where the board has employed a salaried CEO on a 5-year contract; or

2)    A mid cap company where the founder retains majority ownership, is the CEO and Chair.

The multinational blue chip has existed for much longer, so its share price is more predictable, less volatile. The mid cap founder-led company has a much more volatile share price - analysts have a wide variety of opinions regarding its prospects.

But which one is riskier over the long-term? Which company would you rather invest in?

The answer depends on your understanding of the difference between risk and volatility. One investment is more volatile, but is actually less risky over the long-term.

Happy compounding. 

About the author

Lawrence Lam is the Managing Director & Founder of Lumenary Investment Management, a firm that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness. We are a different type of global fund.

Disclaimer: The material in this article is general information only and does not consider any individual's investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations. Ownership of this publication belongs to Lumenary Investment Management. Use of this material is permitted on the condition Lumenary is acknowledged as the author.

Click here for Part I of this series

In this second part we will consider the current standing of the larger EM countries and then review long term performance of the various indices and, and in the process demonstrate that active management is very effective in less efficient markets.

Let's turn now to the state of the larger EM countries. It is surprising to many just how big the largest emerging markets are already.  China and India together are already bigger than the US or Europe.  

The main emerging market powerhouses are China and India.

• Together, these two countries are home to over 35% of the world's labour force and population.
• In 2018, their combined gross domestic product (about US$28.1 trillion) was greater than that of either [1]:
  • the European Union ($18.8 trillion) or the
  • United States ($20.5 trillion).

In any discussion of emerging markets, the powerful influence of these two super-giants must be kept in mind.

Whilst countries like India and China are still in the EM index, it is worth looking at the next table which compares them to the framework introduced earlier and considers just how emerging they still are.  Putting aside the geopolitical and trade factors which can cloud the conversation it is, we believe, reasonable to view a few of the EM countries as no longer emerging, or at least getting close to that stage of their journey as a nation.

If we take a historical and visual look at Emerging markets and Asia ex-Japan we can see  in the image below how Asia ex-Japan used to be a niche subset of Emerging markets, compared to Developing markets (DM)

That, in our view, is no longer the case.  Almost unnoticed, Asia ex-Japan has become the dominant (80%) part of EM.

Where we are starting from today - and are heading very quickly - is shown in the following images where we recategorise Developed markets as The Western economies (including Japan) and separate Asia ex-Japan and the Frontier markets/commodity countries.

This contention carries compelling investment implications.    The underpinning of these changes in large part is a theme that will have at least a full decade of strong growth as the poor of Asia climb into middle class.   

Strategic allocations and portfolio construction need to catch up and to rethink the use of emerging market funds.  As a minimum we suggest that advisers take 80% of EM into an Asia ex-Japan specialist and add to that a Global resource/commodity specialist. 

The obvious question following our contention is; "what do the numbers say?"  The chart below, whilst busy, tells a compelling story.  Note: Saudi Arabia is not included as it does not have a long enough history but over five years its story is consistent with our contention.

Some key observation to assist in understanding the implications of this chart:

• At the bottom is MSCI Brazil.
• The second from bottom is MSCI Emerging Market index excluding Asia.  This index provides long term support for a contention from Part One that the non-Asia components of EM indices are performance detractors.
• Moving up you can see a quite well-correlated South Africa and Russia.
• Next there is the MSCI full EM index.
• Above that - as would be expected given the underperforming countries - is the Asia ex-Japan Index.
• The top line shows the value of a specialist active manager in a less efficient market.

In summary, investing in an Emerging Markets Fund is primarily an investment in Asia ex-Japan, and the remaining approximately 20% has detracted from long term performance by comparison.  We therefore contend that it is a better outcome for clients to use a specialist Asia ex-Japan that has a strong China capability and if the commodity exposure from EM funds is desired we argue a specialist in either Global Resources and/or Commodities is more effective.

[1] Source: Emerging Market Countries and their 5 Defining Characteristics; Kimberley Adao www.thebalance.com; Aug 2020

Often cited as the densest year of technological innovation of all time, 1995 stands out for several reasons; The launch of the world's first internet enabled marketplaces (Craigslist and eBay), the start of online dating (Match.com), the first fully digital, animated feature film (Pixar's Toy Story) and of course, a humble "bookseller" was born (Amazon.com). While lesser known, 1995 was also the year the greatest internet startup in antipodean history was founded, REA Group.

Just like the great tech tales of Silicon Valley, our Aussie protagonist (REA Group) was started in a garage (1995), IPO'd just before the dotcom bust (1999) and lost ~90% of its value shortly thereafter (2001).

However just before complete failure, it was dealt a dose of good fortune, with Rupert Murdoch and his global media empire, News Corporation stepping in and providing a much-needed capital injection. News Corp. took 44% of REA Group (realestate.com.au at the time) in exchange for A$2 million in cash plus A$8 million worth TV and print advertising, giving REA Group a total equity valuation of A$23 million.

Fast forward twenty years to today and News Corp. owns 61% of REA Group which has a market capitalization of A$21 billion, or 910 times the valuation Murdoch paid in 2001. For comparison, a purchase of Amazon stock at its low point after the dotcom bust would have returned 510 times the initial investment today, or less than two-thirds what REA Group delivered (excluding dividends), which earns it a place among the greatest internet start-ups of all time.

Aside from being a multi-decade compounder for shareholders REA Group holds one of the most privileged positions in real-estate of any company in the world. Real-estate markets tend to be highly localized, with the comparable property radius only extending to surrounding neighborhoods, creating fragmented, non-uniform supply dynamics, which are highly supportive for an online marketplace like REA Group which can aggregate that supply more uniformly.

In addition to this, the Australian market is unique, in that it is impossible to function as a real-estate agent (or broker) without a subscription to REA Group's professional tools and access to its property listing portal, which as we will discuss, is entrenched with buyers and renters in the Australian market.

Through its flagship portal (realestate.com.au) REA Group has become "the destination" for real estate in the Australian market with ~65% of Australia's adult population (12 million people) checking property listings, real estate news, and home prices on the site every month.

Additionally, REA Group continues to increase its lead over the number two player (Domain Holdings), reaching 6 million more Australians and attracting over three times the monthly visitators of its peer, a gap which continues to widen.

REA Group is Australia's #1 Property Portal

Source: REA Group

Adjacent to its privileged position with Australian real-estate customers, REA Group also has an indispensable relationship with real-estate agents. To effectively operate in the Australia market a real-estate agent has very few choices outside of subscribing to REA Group's agent administration tools to find clients, build an online profile and market their listings, this has translated into extremely strong and durable pricing power for REA Group.

While the official strategy is to support agents and remain in their servitude forevermore, one cannot help but observe the increasingly potent value-added services it offers property buyers, sellers and renters, slowly disintermediating agents in the value chain, which is the natural progression of a genuine two-sided marketplace like the one REA Group oversees.

As REA Group continues to reduce friction costs of buying, selling, and renting properties for customers, it is likely to capture a larger share of transaction economics over time.

In Part-II of this series will discuss some of the powerful levers REA Group has at its disposal to increase its share of Australian real-estate industry economics and the numerous other valuable real options it holds within its portfolio. We are very grateful for the trust you have placed in Montaka Global to protect and grow your wealth, alongside our own wealth, and believe REA Group will continue to be a wonderful investment over the long-term.

Click here for Part II of this series

Our contention is that use by date of Emerging Market  (EM) funds has passed and that this has quietly happened over the last decade without much notice.   In Part One of this discussion we will look at the make up of EM Indices and their comparison to Asia ex-Japan funds.

What we will outline is that a decision to invest in an EM fund is already mainly a decision to invest in Greater China and the rest of Asia ex-Japan.  What is leftover in EM are countries that are speculative commodity countries largely with questionable or poor governance.  We contend that there are better ways of accessing resources and commodities than via a generalist manager.  Specialists for both are the better way to improve investment outcomes.   

As well it is reasonable to think that some of the emerging markets - particularly Greater China have in fact emerged. What that means for investing is a rethink about asset allocations.

Let's start our discussion with a quick look at Emerging markets.  Following is a framework for assessing emerging market status[1]:
 

1. Lower-Than-Average Per Capita Income
   
   The World Bank defines developing countries as those with per capita income of $3,995 or less.
    
2. Brisk Economic Growth
3. High Volatility
4. Currency Swings
5. Potential For Growth - successful, rapid growth can also lead to the fifth characteristic, which is the higher-than-average return for investors.  That's because many of these countries focus on an export-driven strategy. They don't have the demand at home, so they produce lower-cost consumer goods and commodities for export to developed markets[1].
    

In China, Taiwan and Korea, and to some extent India, however you can already see a clear shift to consumer led economies vs export led.

Let's start by breaking down the Emerging markets.  If you consider the table below - Emerging Market Breakdown using the MSCI - what you can clearly see is that 75% of the index is made up of four Asian countries: China, Taiwan, Korea and India.  Some EM indices also include Hong Kong which would further increase the dominant Asia exposure.

Looking into the smaller weights, we then come to a group of four which represent the next 14% of the index.  Brazil, South Africa, Russia and Saudi Arabia.  These countries have two things in common in our view:

1. They are all commodity countries which we contend are best invested in through a global resource or commodity specialist manager.
    
2. For different reasons, they also have questionable governance or corruption concerns, further increasing the need for specialist understanding, if not on the ground presence.
    

The final cohort of 19 countries in total represent only 11% of the index and individually and together are largely rounding errors, without also considering the Social and Governance challenges some face.

Emerging Market Breakdown (per MSCI 31.3.2021)
Note:  8 other countries are included in some EM indices - e.g., Hong Kong & Vietnam

Let's now dive a little deeper and look at the next chart which shows that an EM investment is effectively already an Asia ex-Japan investment with a dominant exposure to Greater China.

EM and Asia ex-Japan deeper dive

These charts show that investing in Emerging Markets IS already an Asia ex-Japan investment, but:

• With the addition of volatile and mostly detractor countries, and
• Missing what is arguably the strongest global thematic of all - an historic and enormous rise of middle class out of poverty.

So, to us this reinforces our contention that specialists are a better approach to investing in emerging markets.  Use of an Asia ex-Japan specialist with a deep China understanding combined with a Global resources or Commodities specialist makes more sense than an allocation to a generalist EM fund.

[1] Source: Emerging Market Countries and their 5 Defining Characteristics; Kimberley Adao www.thebalance.com; Aug 2020

Based on Plato's analysis, 2020 was the worst year for dividends in Australia over the past forty years, with the 35% cut in dividends surpassing the falls seen over three years in the recession we had to have and the GFC. 

For investors holding just bank shares, the outcome was even worse, with big four bank dividends falling roughly 60% in calendar 2020. Self-funded retirees also took a huge hit on their interest income, with term deposit rates plunging to near zero.

But that was last year. We faced nationwide lockdowns, no one knew how bad things may get, many assumed the worse, the Reserve Bank of Australia slashed rates to an all-time low of 0.1%, APRA initially discouraged banks from paying any dividends at all, and the Federal Government literally threw money at COVID with its Jobkeeper and Jobseeker payments.  As we have seen, Australia's island quarantine strategy has proved relatively successful, in fact very successful on a global context.  Our economy has bounced back quicker than anyone thought, and our GDP has now surpassed its pre-COVID levels. For most companies, too, the outlook is bright, apart from those still directly affected by international travel bans and local lockdowns. On our analysis, 2021 has emerged as very strong year for dividend income and with the August reporting season ahead we expect the good news for dividend investors to continue into the remainder of the year.

The picture for income from ASX-listed equities is stark when compared to other asset classes. Below we've charted the real earnings on $1,000,000 from the overnight cash rate, 1-year term deposits and 10-year bond yields. These so-called safe assets are producing negative real rates of return.

So, in a world where real returns on cash-backed assets are in the red, and will likely remain there for the foreseeable future, how can investors ensure they don't miss out on a piece of the dividend pie?

The dividend outlook looks good

We model expected dividends for S&P/ASX300 companies and our expectations for future dividends is looking very bright. We also forecast the likelihood of companies potentially cutting their future dividends. This helps us avoid dividend traps, which we think is key for income investors. 

We can use our dividend cut model to get a picture of the market as a whole, by calculating the average probability of a dividend cut across all stocks. The following chart shows how the probability has varied over time. The GFC in 2008/9 and the COVID pandemic in 2020 are very clear to see. The global pandemic set a new high for market wide probability of dividend cuts, but what is very interesting is how quickly the cut probability has fallen from its peak in April 2020 to a below average level. This underpins our positive outlook for dividends in 2021.

Source: Plato Global Dividend Cut Model

Diversify, but don't set and forget

We manage the portfolio of our Listed Investment Company, the Plato Income Maximiser (ASX:PL8), with the aim of paying monthly dividends and delivering investors above-market levels of income annually. It may come as a surprise that the majority of our top yielding holdings aren't what many consider to be Australia's traditional dividend-paying stocks.

Consider the miners. 3 of the top 6 dividend payers in Australia today are mining companies - Fortescue Metals (ASX: FMG), Rio Tinto (ASX: RIO) and BHP (ASX: BHP). For many investors this would have been inconceivable just a few years ago.

We've held a very positive view on the sector for a number of years, comfortable with the global supply/demand equation for iron ore. Over the past three years, FMG, RIO and BHP alone have delivered our portfolio 3.4% p.a. gross income.

The question we now face is how long will the mining stock dividend boom continue?

We still maintain a positive outlook on mining stock dividends for the foreseeable future. Our experience in active equity management has taught us things always take longer to play out than markets would indicate.

Samarco (the massive Brazilian Iron Ore miner owned by BHP and Vale) is only just coming back to full production five years after a devastating dam disaster. We often see miners forecast swift production resumption after major issues, but the reality is it usually takes longer. The COVID situation in Brazil is also another impediment.

Even when this Brazilian supply comes back on, steel production is on the rise with historical levels of infrastructure stimulus leaving the supply and demand fundamentals intact. Should Iron Ore prices for come off $100-$150 per tonne from the current highs, Fortescue, Rio Tinto and BHP will still be very profitable businesses.

Mining stocks do go through cycles, and this fact shouldn't be ignored. It's why a 'set and forget' approach isn't optimal for dividend investing. We like miners for the short-medium term, but our view is likely to evolve in the future as conditions change.

The same applies to retailers- again not a traditional area for dividends in the eyes of income investors - however it's a sector that has produced exceptional income in recent times for investors who have actively added the right names to their portfolios.

In the consumer discretionary space in particular, leading retailers including JB Hi-Fi (ASX: JBH), Super Retail (ASX: SUL) and Harvey Norman (HVN) have been thriving and delivering income far superior than most other asset classes.

These consumer discretionary businesses (and others) experienced a COVID-19 sugar-hit has consumers stocked up on products needed for working from home and increased domestic tourism, and we expect this to continue until borders are opened.

So, like the miners, as active managers we must consider if this will continue into the short-medium term.

It remains to be seen when full-scale international travel will resume. Australians love to travel and spend a lot of money abroad. A large chunk of that money is likely to continue flowing into domestic discretionary spending. There was evidence of this recently.

When it comes to the big 4 banks, they've traditionally been a major focus for income investors but in 2020 the outlook appeared dire as dividends were slashed across the board amongst the financials.

There has, however, been a remarkable turnaround, for three reasons. First, APRA have taken off all restrictions on bank and financial institution dividends in late 2020. Second, bad debts have proven much lower than expected, and finally, banks are seeing good loan growth fuelled by low interest rates.

In May we saw half-year results from Westpac (ASX: WBC), ANZ (ASX: ANZ) and National Australian Bank (ASX: NAB).

Across the board, there has been a significant write-back of provisions and strong increases in cash earnings, resulting from improving economic conditions.

Outside of the big 4, dividend strength is also evident. Bendigo and Adelaide Bank's half-year result earlier this year came in at almost 30% above expectations, Macquarie's FY21 net profit revealed in May, was up 10% on FY20.

While bank dividends aren't fully back to pre-COVID levels we believe the outlook is very positive for the sector and think Financial are once again an important element of a diverse equity income portfolio.

Individual dividend investors who set and forget can see their income plunge when the typical dividend stocks go through tough patches - such as the banks during the royal commission or the peak of the COVID crisis.

On the flip-side we're able to take a dynamic approach to generating high yield, moving around the market at any point in time to find the strong dividends and capital returns.

Dividend income to make ends meet

In our low-rate world, effective dividend investing has been a shining light for income-seeking investors. With Australia seemingly through the worst of the COVID-19 crisis the outlook for dividends is on the improve.

Looking forward to the remainder of 2021 and into 2022, we think there's a positive outlook for dividends, particularly from ASX iron ore miners, select consumer discretionary and the banks. 

Diversification, active management, and tax-effective investing can help fire up the dividend machine and ensure investors, who rely on their capital for income, don't miss out.  

Dr Don Hamson is the managing director of Plato Investment Management - a Sydney-based fund manager dedicated to maximising income for retirees, SMSFs and other low-tax investors.

As society was exhaling from the post-war world of 1946, Arthur Lefford from NYU's Department of Psychology took particular interest in people's decision-making ability, especially as many generations (if they were so lucky) had just survived several globally disruptive periods. The new world presented choices and options that could lead to solutions on the social and economic problems that were now presented before them. This evolving case study provided Lefford the platform to challenge whether people expressed the (in)ability to act based on objectivity and rationality. Unsurprising to many of us in 2021, the results of the study found that people's agreeability to a message is often strongly correlated with their perception of the choice being more logical or rational. The inverse also applies; when there is disagreement with a message, people often consider this to be emotional. Decades later as the natural progression of this field of study cascaded into the world of finance, behavioural finance emerged and sought to study the effect of psychological factors on the economic decision-making process.

The focus of behavioural finance is the idea that investors are limited in their ability to make rational economic decisions, whether that be influenced by their own biases, by a lack of self-control or resources (i.e. time), by peer pressure (i.e. herd mentality) or a number of other social, cultural and external factors. If studied and watched closely, this irrationality can begin to reveal some patterns of behaviour and can lead to opportunities. The opposing camp to behavioural finance however, is the Efficient Market Hypothesis. The Efficient Market Hypothesis asserts that investors are rational, fully-informed, and that (stock) prices reflect all available information at any given time and therefore always trade at their fair value. Essentially making the ability to generate an excess return impossible.

From our perch, it currently appears that the broader financial system may be playing out a behavioural finance tragic's greatest fantasy. Alongside the apparent equity market exuberance and interest in speculative assets, it seems experts and arm-chair journalists are also attempting to forecast when the RBA interest rates will begin to rise. Whilst these pre-emptive calls make for fascinating reading, they can feed into the broader market's fear & greed complex. Simply, when interest rates are rising (or are lifted ahead of schedule), people are fearful they won't be able to pay their (increased) mortgage repayment and when they are declining (or are cut AHEAD of market consensus), greed dominates as money is perceivably cheap(er). From a business perspective, when interest rates rise, it tends to have a detractive effect overall as debt becomes more expensive (increasing the cost of starting new projects, assuming they are partially debt funded), consumer spending rates generally reduce, and cash leaves the system to be channelled elsewhere (e.g. the household mortgage). The converse also remains true, should interest rates be lifted at a point which is BEHIND consensus, this may allow markets to continue climbing further over the near term.

Interestingly however, should interest rates rise ahead of schedule and shock the market into price recalibration to reflect this new environment, one would expect fear and by that virtue, volatility to accompany irrationality as it replaces the current market exuberance. Perhaps this is what pundits and experts alike are trying to time or forecast. Timed correctly, one can quickly adjust a portfolio on a value vs growth or technical vs fundamental basis with the intent to be in the more favoured style. We however prefer not to market time or fluctuate between styles to try and match the macro environment. Conviction (or lack thereof) to an investment strategy and ethos can often be the difference between consistent and inconsistent returns.

It appears quite likely that at some point in the medium term the RBA will lift interest rates; from the lens of our investment strategy, we believe that timing this movement is largely an exercise in futility. For as long as irrational economic decision-making continues, one can expect volatility and with it, market opportunities for those who look.

As Australian equities have rebounded from the lows of late March 2020, many investors have doubted the rally's staying power. Pessimists argue that, based on most valuation metrics, stocks are pricey, which implies weak returns ahead.

But we believe that this overrates the predictive power of valuations - particularly in the short term. Instead, investors need to understand that long-run equity returns are driven by multiple components, of which valuation is often the least important.

Indeed, it is likely that in coming years investors won't be able to rely on rising equity valuations for their returns. To achieve high returns and realise their investment goals in this environment, they are going to have to become even more focused on identifying the companies that can produce strong earnings growth and cash flow.

Only 3 components

                Source: Refinitiv

Figure 1 above decomposes Australian equity market returns into their key components. As you can see, there are only three sources of returns:

• Income (grey bar) - dividends
• Earnings (orange bar) - how fast have companies grown their earnings?
• Valuations (blue bar) - how has price/earnings multiple changed? Does the market now value companies more or less for a given level of earnings?

The first two components of return are generally referred to as the 'fundamental' components, whilst valuations are often referred to as the 'speculative' component of return. The latter has earned this moniker because it is driven by unpredictable investor emotions, such as fear and greed, in the short term. (The sum of these components approximates the return on the stockmarket, shown with a black diamond.)

An erratic contributor

The sources of return never change. But their order of importance does. That is, during any of the five-year periods presented, one of these variables will exert a disproportionate influence on total equity returns. Conversely, there will be periods where a component makes little contribution.

There is no doubt that when valuations expand it can have a dramatic positive impact on total return. But valuation's contribution is highly erratic: sometimes positive, sometimes negative. When the P/E ratio expands, the stock market generally produces double-digit returns. And when the ratio contracts, returns fall into the single digits.

In the second half of the 1980s and the second half of the 1990s, for example, the P/E ratio was a strong driver of the era's spectacular market returns. But P/E detracted from market performance through the years 2000 to 2015 when valuations subsided from the start of the high tech bubble.

The exhaustion of PE expansion

When P/E multiples are expanding, interest rates are typically falling, and vice versa. For the two decades between 1980 and 2000, the downward trend in interest rates boosted P/Es, which resulted in huge growth in total equity returns.

More recently, we have seen this play out as central banks worldwide have drastically cut interest rates to support economies facing pandemic pressures.

But with interest rates now having already been reduced to the floor, the era of P/E expansion has been exhausted: it is unlikely that rates can fall much low and push further P/E expansion. Instead, rising rates over the coming years -as economic growth recovers -- are likely to force a modest decline in equity valuation multiples, similar to what markets digested through the years 2000 to 2010.

This negative outlook for P/E ratios emphasises the other two sources of equity return: earnings and dividends. As you saw in Figure 1, earnings and dividends, unlike the highly volatile P/E ratio, have had a consistently positive effect on total return over the last forty years. In fact, for much of the last twenty years, earnings and dividends have continued to boost total return, while P/Es have hindered market performance.

The emerging primacy of earnings and dividends

But while earnings and dividends become more important as sources of returns, the period of double-digit earnings gains for the broader equity market will soon be behind us as economies normalise post the COVID-19 pandemic. Going forward, earnings growth will likely occur at a more modest single-digit rate.

Fortunately, our investment process has always focussed on finding the companies that can materially grow earnings. In this environment, our expertise in identifying the profitable growing businesses of the future comes to the fore.

Meanwhile, because they are often a preferred method of free cash flow deployment, dividends are set to emerge as a more important component of total equity returns. Although we are biased to companies that can grow earnings faster than the market, we will continue to learn everything we can about a company's free cash flow and what it signals for the businesses capital management policies.

A solid year of returns from equities

Valuations are not good predictors of short-term market returns. It is futile for investors to use valuations to time the market day-to-day or month-to-month.

Valuations could fall but that does not mean returns have to be negative if the other two drivers contribute enough.

For long-term investors, the best course is to continue investing according to your plan, regardless of what the market does. You may, at times, buy when valuations are high; on other occasions, you will buy when valuations are low. It should all come out in the wash over the long term.

Our base case is we expect a year of solid returns from equities in 2021, but with the usually very high degree of uncertainty. At a very high level, the global economic recovery, which is currently playing out, suggests that earnings growth should positively contribute to markets in 2021. The big differences could arise from valuations. Dividends should also be well supported this year, particularly in commodity and consumer-related stocks.

We think investors can no longer rely on a rising tide of higher valuations to lift all stocks. Alpha or outperformance, where it can be found, we be a larger portion of total investor returns. For us, we will continue to focus on finding undervalued small and mid-cap companies that through a superior product or service can one day become the future leaders of tomorrow. These type of businesses will continue to be rewarded with expanding valuations as the market recognises their superior growth trajectories.