February 11, 2011
Written By David Baskin
By David Baskin in The MoneyLetter: “Last month we closed out a tumultuous decade for the stock markets. The last ten years saw two major crashes: the tech wreck of 2001/2002 and the great recession and banking crisis of 2008. The twin disasters were separated by a terrific bull market and to cap off the period, the major market indices ended 2010 with a 50% gain in the last two years. The dramatic ups and downs caused successive waves of despair and exuberance. Some commentators, looking at the volatility, have declared that the age of ‘buy and hold’ style investing has ended. We beg to differ.
“The facts are that even with all of the huge swings in the first decade of the century, those who bought stocks and held them for at least five years did well. An investor who bought the TSX (Toronto Stock Exchange) 300 index on December 31, 2000 would have had an average (not compounded) gain of 7.08% a year for each of the past ten years. That is about twice as much as the average yield of bonds during the period, not even taking into account the lower tax rates for dividends and capital gains.
“Ten years is a pretty long time, but an investor who stuck with the market for only half as long also did pretty well. Here are the average yearly returns for every five year period in the last decade:
2000 to 2005 6.84 % a year
2001 to 2006 15.32 % a year
2002 to 2007 23.70 % a year
2003 to 2008 2.38 % a year
2004 to 2009 7.66 % a year
2005 to 2010 6.32 % a year
“Note that even an investor who bailed out of the market at the worst possible time—at the end of 2008 following the worst stock market crash since the great depression— would still have made an average of 2.38% over each year of the five year period, a return comparable to that on bonds.
“It is certainly true that an investor blessed with perfect foreknowledge of the direction that the markets would take would have done better to invest in 2002 following the bursting of the tech bubble and to hold until 2007, cashing out with a stellar gain of over 23% a year on average. The same prescient investor would then have stayed out of the market until March 2009, and re- invested at the bottom that month, making an even more impressive 80% gain over the next twenty-one months. But in the real world, no one does that. In fact, quite the opposite happens. … Only in the past few months, after the TSX recovered by 6,000 points, or 80%, and after the S&P 500 rebounded by 600 points, or 90%, have we seen significant movements of funds from safe haven investments back into equities. There is no way that investors who sold at the bottom and are buying now can match the returns of those who simply stayed in the market. … It is worth considering why the stock markets (in our specific case the TSX) provides such good returns over time. In our view, there are three important reasons.
• The cumulative impact of dividend income. During the past decade, the TSX Index had an average dividend yield of 2.26% a year. Through good times and bad, the dividend income was paid to shareholders. In fact, during the crisis of 2008, more blue chip Canadian stocks raised their dividends than lowered them. None of the big banks, only one of the big insurers, and none of the major telecom companies, utilities or pipelines cut dividends during the worst recession of the past seventy years. Even if stock prices had stayed flat over the decade, investors in stocks would have made a return comparable to that on short terms bonds, and better than the return on money market funds.
• Markets provide steady returns over the long run. Stock markets are a proxy for the entire economy. We expect economic growth every year, usually around 3% or so. In general, a broadly representative group of stocks will have growth in revenues and earnings at about the same rate as the economy, and in some periods, at a greater rate. Corporate profits as a percentage of all income in the economy fluctuates, but in the long term it is pretty stable at about 10%. An investor in stocks of a growing economy will therefore get a share of the growing corporate revenue and corporate profits. And all things being equal, share prices should trend upwards by the same amount. If we can assume long term growth in the economy averages 3% a year, buying the market should, over time, result in share price appreciation of about the same amount.
• Inflation benefits stocks. When prices go up, corporate revenues and profits follow. Even inflation as low as 2% a year, which is what we have seen in Canada over the past decade, tends to increase reported profits by about the same amount. In contrast, inflation is the enemy of bonds, eroding the principal value over time.
“Add up the above three factors: dividends of 2%, earnings growth of 3% and inflation of 2%, and you get about 7% a year. The return on the TSX from January 1, 2000, to December 31, 2010, was 7.08% a year. In the fifty years from 1958 to 2008, the TSX index grew by 7.2% a year. Anyone who has ever bought a stock knows that the market is not linear, and all the facts we can quote about fifty-year returns are little comfort when we suffer a blow such as the one the market took from September 2008 to March 2009. But the facts remain: two years down the road the only investors who were seriously damaged were the ones who sold out during the market plunge. Those who held on have seen their portfolios recover all or most of the amount that was lost.
“Our advice has been consistent over all the years we have managed money. Buy good quality stocks, enjoy the dividend income and growth in earnings over time, and leave marketing timing to the masochists. In our view, this style of investing will never go out of fashion.”
David Baskin, The Moneyletter, February 2011