ANALYSIS

Equity risk premium appears intact

Investors should expect to continue to earn an equity risk premium comparable to a 3.8 per cent historical long-term average, based on new analysis that quantifies the effect of share buybacks – and the decline of dividends – as a major driver of equity returns.

An article by the head of capital markets and asset allocation at Morningstar Investment Management, Philip Straehl, and Professor in the Practice Emeritus of Finance at the Yale School of Management, Roger Ibbotson, highlights the importance of including share buybacks in calculating a “payout yield” for equities.

In the article, “The Long-run Drivers of Stock Returns: Total payouts and the real economy”, published in the Financial Analysts Journal, Straehl and Ibbotson argue the importance of share buybacks is often overlooked but their impact on equity returns can no longer be ignored.

In the July 2017 edition of The Ambachtsheer Letter, KPA Advisory Services’ Keith Ambachtsheer says the good news for investors is that based on what he believes is a reasonable set of assumptions underpinning equity return forecasts by Straehl and Ibbotson, “forward-looking equity risk premium today looks a lot like its historical counterpart”.

Danger of underestimating future returns

Getting an accurate and meaningful bead on the equity risk premium remains of prime concern for long-term investors seeking to allocate capital efficiently across different asset classes and varying periods of time. Opinions remain divided on what the figure is, and even on a suitable definition.

The traditional and widespread approach to forecasting returns using dividend yield and expected growth in dividends, while ignoring buybacks, will cause future returns to be underestimated, Ambachtsheer says.

As the importance of share buybacks becomes better understood and is factored into calculations, the effect of potential underestimation becomes clearer.

The Straehl and Ibbotson FAJ article states “the cash flows that corporations supply are the ultimate drivers of stock returns”, and since the early 1980s, buybacks have become an increasingly important part of that supply, exceeding dividends in eight of the last 10 calendar years.

What matters, the article states, is the combination of dividends and buybacks, and buybacks have “a fundamentally different impact on the return generation process than dividends”.

Dividends result in cash in the investor’s pocket, whereas buybacks affect growth by increasing the equity price return for buy-and-hold investors, whose stake in a company increases. Not taking this price growth into account can be a factor in underestimating future returns.

“The advent of share buybacks as the dominant form of payout has created a need for a new set of return models that are independent of the payout method,” the FAJ article states.

Buybacks’ growing importance

In analysing the return from US stocks for the period 1871 to 2014, Straehl and Ibbotson based their calculations on a dividend yield of 4.5 per cent a year, buyback growth (BBgrowth) of 0.8 per cent a year and dividend growth of 1.5 per cent a year – giving a real return of 6.8 per cent a year. However, looking ahead, they base their estimates on a current dividend yield of just 1.9 per cent and buyback growth of 1.7 per cent, the average of the last 10 years.

Ambachtsheer says: “A key message in the [Straehl and Ibbotson] article is that, based on the assumed continuation of the average share buyback experience of the last 10 years, the BBGrowth factor is almost as important as the current dividend yield in calculating the expected long-term return of a broadly based equity portfolio today.”

The Ambachtsheer Letter states that the historical 6.8 per cent a year long-term real return from US equities and the 3 per cent real return from US Treasury bonds implies a historical equity risk premium of 3.8 per cent. However, today’s real bond return is about 0.8 per cent, implying an equity risk premium of 4.4 per cent – based on the average of Straehl and Ibbotson’s forecast of a real return from US equities of 5.1 per cent and what Ambachtsheer says is the projected 5.3 per cent from the S&P 500 Index.

Ambachtsheer says Straehl and Ibbotson’s payout yield calculations support his own analysis that with bond yields at their current levels “the prospects for earning a positive equity risk premium…continue to be good at today’s stock price levels”.

He says bond yields could rise to 1.4 per cent before they begin to affect the 3.8 per cent historical equity risk premium. But the factors depressing bond yields are secular in nature and “unlikely to be reversed any time soon”, he argues, and investors will continue to earn an equity risk premium at or near historical levels.

In 2011, the Research Foundation of the CFA Institute published a collection of papers, Rethinking the Equity Risk Premium, which contained the results of 19 separate studies calculating the equity risk premium in a range between zero and 7 per cent.

“The papers collected in this volume share a general emphasis on supply factors and models for the historical excess return as well as the forward-looking equity risk premium,” the CFA Institute publication states. “After 10 years of low and highly volatile equity returns, there is little consensus about the stability of the [equity risk premium] over changing regimes and time horizons. Interestingly, the group appears to be in agreement more on the actual size of the ERP over the next few years (most agree that it is in the 4 per cent range) than on its stability.”