Mar 2015: Have Realistic Expectations from Long Term Equity Returns

Although the Nifty was weak in March, it did finish the year with a very strong performance for the year at 26.7%. Over the last decade, this has been one of the better years for equity investors, especially if you discount FY2010, when the Nifty was up 74% following a very weak FY2009 (Nifty down 36%). Our portfolios on the aggregate, performed quite strongly, and were well ahead of the market. This has been one of our strongest annual performances over the last decade. However, one thing is for certain – we will not see a year like this for our portfolios for a long time to come. Such strong performance is rare, especially in the context that the nominal GDP growth is closer to 15% p.a. over long periods of time. It is important for investors to have realistic expectations with regards to long term equity market returns, and the following note should help you form a reasonable basis for setting long term expectations from equity investing.

Over long periods of time, the return from equities would need to necessarily converge to intrinsic value growth of the constituent companies. Intrinsic value growth of companies, which to a large extent is dependent on sales and net profit growth, has been averaging about 15% per annum – in line with India’s nominal GDP growth. Assuming an investor buys a company, which is growing intrinsic value at 15%, at a price that is fair – over time investor returns will converge to that number. Some investors may make more, or less, based on whether they buy these companies at a discount or premium to intrinsic values.

A value investor hopes to buy stocks at a reasonable discount to the intrinsic value. In a typical year, the high grade companies are available, at best, at about a 20-25% discount to their intrinsic values, which over a 3-4 year period, can add another 5% pa, to the value investor’s return, over and above the long term intrinsic value growth of companies.

So, then how does one explain the aberration in returns in the current year. Due to a combination of reasons, markets were very weak from the end of 2011 to mid-2013 – some of the macro reasons seem forgotten now but we have discussed some of these in our earlier letters. As a result, we found some high grade companies at substantial discounts to intrinsic value – far higher than the normal discounts that we see. Because the gloom and doom persisted in markets for quite some time, we had enough time to populate portfolios with some of these high quality companies at very attractive prices. So, the real work was done then – the fruits of that are only apparent now when Mr Market is not so despondent.

Under normal circumstances, companies tend to trade in a band around their intrinsic values – this is especially true for stable, mature companies. There is some volatility around this figure, as intrinsic value itself is not a perfect number – different investors’ estimate of intrinsic value may vary depending on the assumptions made. The job of a good investor is to ensure one buys into companies, where there is a reasonable certainty of intrinsic value growth, and buy these companies at some discount to intrinsic value. When these two conditions don’t exist, your money is better off in the bank, and wait for such conditions to emerge. The market correction over the recent few weeks seems to suggest it is time to give notice to the ‘money in the bank’ and look for some opportunities that may have presented themselves.