The
famous economist John Maynard Keynes once said that in the long run, we
are all dead. It appears that the most of the investment community and
financial media seems to have taken this comment rather seriously. What
else will explain their fascination behind employing an entire battalion
of analysts and economists in order to study the short term impact of
an economic event of note? The end result? Extremely volatile share
price movements and swings of the magnitude of 20%-30% becoming a common
occurrence.
But is this approach correct? Certainly not if one realizes where does the value of stocks really come from and their longevity. There cannot be any ambiguity with respect to the fact that stocks are worth the present value of future cash flows they will deliver to their owners. But do they have an expiry date? Well, individual stocks may decline and the business models behind them disappear altogether. But if considered together as a group, their duration is extremely long and the dividends they pay out do certainly grow with time.
Thus, if we assume, like the famous asset management firm GMO has done, that half of the returns from stock in a given year come from dividends and half from growth in dividends, it becomes clear that most of the value of stocks comes from cash flows in the distant future. This is because dividend in any year will only be a very small fraction of the overall value accumulated over a very long term horizon.
Well, we will spare you the math here but the broad conclusion that comes out is that the first 11 years of dividend account for only 25% of the value of stock market. Thus, even if dividends are a whopping 50% below the trend over a period of 10 years, the value of the stock market will come down only by 10%. Contrast this with the 30%-40% corrections that stock markets regularly witness over a small downward revision in earnings or dividends and one understands why the markets are so irrational.
It is extremely important to add that if India's GDP grows by 6% instead of 8%, this does not mean that India's capacity to grow GDP by 8% has been impaired completely. It is just that demand for goods and services has grown by 6%. Thus, when the demand returns, the economy will certainly be in a position to absorb the higher production needed. In view of this, whenever events like fall in industrial output, which we have demonstrated to have no sizeable impact on overall valuation of stocks lead to market panicking and pushing down value of stocks by 30%-40%, rational, long term investors can take advantage of the same. They will thus benefit from the attractive above trend returns that lie in waiting for them.
But is this approach correct? Certainly not if one realizes where does the value of stocks really come from and their longevity. There cannot be any ambiguity with respect to the fact that stocks are worth the present value of future cash flows they will deliver to their owners. But do they have an expiry date? Well, individual stocks may decline and the business models behind them disappear altogether. But if considered together as a group, their duration is extremely long and the dividends they pay out do certainly grow with time.
Thus, if we assume, like the famous asset management firm GMO has done, that half of the returns from stock in a given year come from dividends and half from growth in dividends, it becomes clear that most of the value of stocks comes from cash flows in the distant future. This is because dividend in any year will only be a very small fraction of the overall value accumulated over a very long term horizon.
Well, we will spare you the math here but the broad conclusion that comes out is that the first 11 years of dividend account for only 25% of the value of stock market. Thus, even if dividends are a whopping 50% below the trend over a period of 10 years, the value of the stock market will come down only by 10%. Contrast this with the 30%-40% corrections that stock markets regularly witness over a small downward revision in earnings or dividends and one understands why the markets are so irrational.
It is extremely important to add that if India's GDP grows by 6% instead of 8%, this does not mean that India's capacity to grow GDP by 8% has been impaired completely. It is just that demand for goods and services has grown by 6%. Thus, when the demand returns, the economy will certainly be in a position to absorb the higher production needed. In view of this, whenever events like fall in industrial output, which we have demonstrated to have no sizeable impact on overall valuation of stocks lead to market panicking and pushing down value of stocks by 30%-40%, rational, long term investors can take advantage of the same. They will thus benefit from the attractive above trend returns that lie in waiting for them.
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