It is difficult to look beyond the hysteria that currently accompanies commentary about UK stock markets and share prices. Given the uncertainties on the horizon in 2019 and in particular, the Brexit-shaped challenges facing the UK, investors might be forgiven for thinking that buying UK equities any time soon is a mugs game.
Nothing could be further than the truth. The following chart shows the capital only performance of the FTSE All Share index, the broadest measure of stock market prices, over the last 56 years since 1962 when the index was created:
Source: Bloomberg
It is obvious that the long-term trend in share prices is up and this is despite there being a stream of “crises” to unsettle markets throughout that period. The UK stock market is still over 40 times the level it started at back in the early 1960s – and that is without re-invested income. This long-term growth of share prices is despite the accompaniment of regular incidents of doom and despair and is a testament to the long-term, positive return characteristics of equities as an asset class.
Unfortunately, stock markets experience periods of negative returns. Share prices fall for many reasons; falling profits, growing recessionary expectations, political uncertainty and rising interest rates are just four commonly cited causes. Nonetheless, there are actions that investors can take to mitigate the risk of not achieving a decent return. The first and most important of these is to take a long-term view. The following graph shows the total returns generated by investing in the UK stock market for 10-year periods since the mid-1980s.
Source Bloomberg
The graph shows that when taking a 10-year view it has been extremely difficult to lose money in equities. Only in one short period was it possible to make a loss. The unfortunate investor would have decided to take the plunge into equities towards the top of the dotcom bubble at the end of 1999 and then panicked out at the very bottom of the financial crisis 10 years later. But even this would have only recorded a small total return loss.
The chart also shows the importance of investing after market falls. For example, if an investor had bought the market just prior to Black Monday in 1987 they would still have made a respectable 180 per cent total return over the subsequent decade. However, this return rises to 340 per cent if the investment had been made just weeks later after the stock market crash. Unfortunately, it often takes nerves of steel to take advantage of such opportunities.
Investors can also mitigate their risks by focusing on dividend income. Income is a vitally important part of total return as the following chart illustrates:
Source: Bloomberg
There is plenty of statistical evidence to suggest that income focused investment strategies can generate attractive long-term returns, but there is another important reason for concentrating on income. Dividend payments are a far less volatile component of return than the capital element as the following graph of total dividends paid by UK companies demonstrates.
Source: Capita UK Dividend Monitor
Total dividends paid have only fallen once in the last decade and then only by 10 per cent during the worst year of the financial crisis. Since then dividends have been on a steady upwards trend with no down years – unlike the stock market. Dividends are likely to have risen by around 20 per cent since the EU referendum, having been given a turbo boost by the devaluation of the pound and illustrating that not all crises are necessarily bad news for equity investors.
Lastly, investors should of course seek to diversify their holdings and not have all their eggs in one basket. However, there are a number of important caveats to this sensible advice. Firstly, most of the diversification benefits of having a high number of stock investments are achieved by owning just 40 stocks, although it should also be stressed these 40 should not all be in the same industry. Secondly, wide diversification will almost inevitably mean exposure to underperforming assets; many investors may currently be wondering why they “diversified” into emerging markets in recent years on the pretext of reducing risk. Lastly, while it is true to say the diversification reduces risk in “normal” market conditions this was not the case during the financial crisis, when many asset classes that were supposed to be uncorrelated all recorded extreme negative returns at the same time.
In conclusion, would-be investors should always remember that companies have the financial characteristics that enable them to generate attractive real returns for their shareholders over the long-term. They should do their best to ignore the hysteria that often accompanies stock market falls and remember that such falls have almost always been the best time to buy shares. This year will be no different.
Patrick Harrington is portfolio manager at OLIM Investment Managers. The views expressed above are his own and should not be taken as investment advice.