The returns that you’ll get from participating in the stock market will come from two distinct sources. The first is income from dividends, and the second is capital growth from share price appreciation.
Taken together, these have produced real (inflation-adjusted) returns of around 5% over the very long run. That’s considerably more than the returns from either cash or gilts, and it’s the main reason why a large portion of long-term investments are held in the stock market.
Companies generate cash. Some of that cash can be reinvested into the business to build new factories or to be spent on new product research and development. Generally speaking, a company should only reinvest cash within the business when it can get a higher rate of return on that investment than shareholders could by investing elsewhere in the stock market.
Since the stock market has returned around 5% after inflation, or perhaps 8% in nominal terms in today’s inflationary environment, that’s the sort of benchmark that companies should theoretically use when reinvesting cash within the business.
If it turns out that there are no opportunities to reinvest in the company with those rates of return, then the company should give the cash back to shareholders. Those shareholders can then choose to invest the cash where they think they will get a better return.
In the long run, the stock market provides investors with a return of around 3% a year from dividend income.
The thing that attracts most people to the stock market is the lure of capital gains. Unlike cash in a bank or bonds held to maturity, the value of your shares can go up, which of course, raises the value of your investment.
Share price gains and the resultant capital growth can arise in two ways:
The first is when the company gets bigger. If a company doubles in size over a period of, say, ten years then, all else being equal, the shares will double as well.
The second is when Mr. Market pushes up the share price even if nothing about the company has changed.
Mr. Market is a useful metaphor in which all the other participants in the stock market are pictured as a single investor with whom you can buy or sell shares in any company at any time. The price that Mr. Market is willing to buy shares from you, or sell them to you, will depend upon a number of factors, including:
- His need for cash – If Mr Market needs cash, then he will want to sell his shares in exchange for your cash, so he may offer you a low price to encourage you to buy. Alternatively, if he has too much cash, he may offer to buy shares from you at a high price while he’s feeling ‘flush’.
- His rational calculation of what the shares are worth – Mr. Market is a very clever chap. Most of the time, he can calculate the value of a company (and, therefore, its shares) surprisingly accurately by estimating its future cash payments to shareholders and discounting them at an appropriate rate. In this case, you may buy or sell shares from Mr Market when your opinion of the value of a company differs significantly from his.
- His mood, which is based on recent news about the company and the wider economy – Most of the time, Mr. Market is very rational. However, sometimes he gets carried away with the news of the day. When things are going well, he may become excessively optimistic, and that optimism causes him to become greedy. When things are going badly for the company or the economy, he may become pessimistic, and his pessimism makes him fearful of what the future might bring. When he’s greedy, he will be willing to buy shares at a price that is obviously too high (obvious to a more level-headed investor), and when he’s fearful, he will sell his shares at almost any price just to get rid of them.
In the long run, Mr. Market’s cash requirements and mood swings balance themselves out, and so Mr. Market effectively provides no returns to investors in the long run. However, if you can consistently buy from Mr Market when he’s fearful and sell to him when he’s greedy, then you may be able to add a few additional percent to your annual capital gains. While it may not seem like much, a few percent, over a long period of time, can add up to a huge amount.
Even if you assume that you can’t buy low and sell high, the stock market has still produced real returns of around 2% a year as the underlying companies have grown. Throw in inflation at 2-3%, and the market has returned around 4-5% a year from corporate growth in the long run.
Taken together, dividend income and capital growth have produced returns of around 5% a year after inflation, which is why equities are the long-term investment vehicle of choice for so many.
To produce a portfolio that has a higher dividend yield and higher capital growth rates than the market, a defensive value investor should focus on three things:
- High-yield shares – The obvious first step to getting a high yield is to invest in high-yield shares. This is the easy bit because the yield can be found in any number of newspapers or websites. Of course, you want that dividend to be paid, so you should check that the dividend is likely to be sustained over many years.
- Strong, growing companies – Growth does not mean 10, 20 or 30% growth per year. If the market returns just 4-5% from corporate growth over the long term, then you only need to look for companies that can grow a bit faster to massively improve your portfolio’s returns. The quality and reliability of that growth is just as important as the growth rate.
- Buying low and selling high – It is possible to boost capital gains even further by repeatedly buying low and selling high. However, to do this, you will either require a good dose of willpower or a contrarian streak (or both), because you will have to buy when Mr. Market is pessimistic (in other words, when everybody else thinks the company is a bad investment), and sell when he is optimistic (which means getting out just as everybody else is getting in). If you are unable to disagree with other people, then this strategy may not be for you.